Abstract
This paper tests a factor-based explanation for positive excess carry trade returns. Equity market risk of the countries in the carry trade portfolio, a new factor in the literature, is significantly priced after controlling for commonly cited factors. One motivation for this factor is via changes in investors' allocations between equity and safer instruments brought about by changes in risk aversion. Strong equity returns in funding currencies are associated with weak carry trade returns, and vice versa, however equity betas are subject to significant time variation.
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