The Carry Trade and Uncovered Interest Parity When Markets Are Incomplete

Abstract

Many of the leading models of the carry trade imply that, contrary to the empirical evidence, a country's currency depreciates in times of high consumption and output growth, a manifestation of the Backus and Smith (1993) puzzle. We propose a modification of these models to account for financial market incompleteness and show that such a modification can induce positive correlation between currency appreciation and consumption or output growth while, at the same time, helping resolve the Backus and Smith (1993) and Brandt, Cochrane and SantaClara (2006) puzzles. Furthermore, in many of the existing models, the assumed fundamental cross-country differences (output volatility, growth, and risk attitude) responsible for interest rate differentials also appear at odds with the data. We document that default risk and financial openness are strongly related to interest rate differentials and carry trade profits in the data. The incomplete markets model we propose is consistent with these novel empirical facts.