Topic: The Carry Trade and Uncovered Interest Parity when Markets are Incomplete

Speaker: Lorenzo Garlappi, Associate Professor, Sauder School of Business, University of British Columbia

Date: June 21st (Wednesday)

Time: 10:00-11:30am

Location: Building 4, Room 101

Language: English

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 Santa-Clara (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.

About the speaker:

Lorenzo Garlappi is currently Associate Professor at Sauder School of Business, University of British Columbia. He received a Ph.D. in Finance from University of British Columbia in 2001. Dr. Garlappi teaches Asset Pricing Theory for Ph.D, and he also teaches Investments and Financial Risk Management for undergraduate and MBA students. His research interest includes Asset Pricing, Credit Risk and Real Options, Portfolio Choice and Asset Allocation. He has articles published in the Review of Financial Studies, the Journal of Financial Economics, the Journal of Finance, and Management Science among others.