Carry trade and foreign exchange rate puzzles

This article demonstrates that carry trade is part of the explanation of foreign exchange rate puzzles. We introduce carry traders in a heterogeneous agent model in addition to fundamentalists and chartists. Our model has the ability to produce the stylized facts observed in empirical exchange rates, such as heavy tails, excess volatility, and volatility clustering, as well as the negative relationship between market volatility and carry trade activity. We find that the interaction between carry traders and chartists provides an explanation for the forward premium puzzle. This effect is strengthened by chartists, who extrapolate the trend induced by carry trade.

► We introduce carry traders in a heterogeneous agent model in addition to fundamentalists and chartists. ► The model has the ability to produce the stylized facts observed in empirical exchange rates. ► The model replicates the negative relationship between carry trade and market volatility. ► The interaction between carry traders and chartists provides an explanation for the forward premium puzzle. ► This effect is strengthened by chartists, who extrapolate the trend induced by carry trade.