Interest Rate Parity with Credit Risk: Implications for the Carry Trade

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 frictionbased approaches that explain deviations from traditional interest rate parity, I examine the effect of foreign sovereign credit risk and associated sharp currency devaluations on interest rate parity. To ensure that the theoretical implications apply generally, the setting is a continuous time arbitrage pricing model driven by Levy processes. I derive the statements of covered and uncovered interest rate parity under credit risk. The model produces novel measures of sovereign credit risk and carry trade profitability – most notably, forward-implied default intensities and the difference of same-maturity futures and forward prices. Empirically, introducing credit risk into the statement of covered interest rate parity makes pricing errors vanish for Mexico and the G10 countries: The profitability of both the covered and uncovered carry trade are fully accounted for by a modest allowance for credit risk and currency devaluation. I find mixed results for a carry trade trading system whose long/short position is determined by an estimate of the risk neutral expected return to the carry trade.