Interest Rate Parity with Credit Risk: Implications for Carry Trades

Abstract

The incredible profitability of the carry trade over the past six decades constitutes a puzzle for interest rate parity. Contrary to recent behavioral or friction-based approaches that explain deviations from traditional interest rate parity, I derive interest rate parity in a general arbitrage pricing model of foreign exchange with credit-risky sovereign lending and sharp currency devaluations associated with default; in particular, foreign sovereign credit risk makes forward contracts more valuable relative to standard covered interest rate parity. I calibrate the model for Mexico and the United States, and find that credit risk and currency devaluation fully account for the profitability of both the covered and uncovered carry trade. Modest default probabilities are sufficient to explain deviations from covered interest rate parity for G10 countries. I find support for the recent notion that the United States is a global provider of safe assets, via default intensities implied by currency forward contracts.