Do Peso Problems Explain the Returns to the Carry Trade?

We study the properties of the carry trade, a currency speculation strategy in which an investor borrows low-interest-rate currencies and lends high-interest-rate currencies. This strategy generates payoffs which are on average large and uncorrelated with traditional risk factors. We investigate whether these payoffs reflect a peso problem. We argue that they do. We reach this conclusion by analyzing the payoffs to the hedged carry trade, in which an investor uses currency options to protect himself from the downside risk from large, adverse movements in exchange rates