The “forward premium puzzle” and the sovereign default risk Virginie Coudert a, b, * , Valérie Mignon b, c a Bank of France, Financial Stability Directorate, code 35-1537, 31 rue Croix des Petits Champs, 75001 Paris, France b EconomiX-CNRS, University of Paris Ouest, France c CEPII, France JEL classification: G15 G01 C3 Keywords: Carry trades UIP puzzle Default risk Smooth transition regression models abstract Carry-trade strategies which consist of buying forward high-yield currencies tend to yield positive excess returns when global financial markets are booming, whereas they generate losses during crises. Firstly, we show that the sovereign default risk, which is taken on by investing in high-yield currencies, may increase the magnitude of the gains during the boom periods and the losses during crises. We empirically test for this hypothesis on a sample of 18 emerging currencies over the period from June 2005 to September 2010, the default risk being proxied by the sovereign credit default swap spread. Relying on smooth transition regression (STR) models, we show that default risk contributes to the carry-trade gains during booms, and worsens the losses during busts. Secondly, we turn to the “Fama regression” linking the exchange-rate depreciation to the interest-rate differential. We propose a nonlinear estimation of this equation, explaining the puzzling evolution of its coefficient by the change in the market volatility along the financial cycle. Then, we introduce the default risk into this equation and show that the “forward bias”, usually evidenced by a coefficient smaller than unity in this regression, is somewhat alleviated, as the default risk is significant to explain the exchange-rate change. Ó 2012 Elsevier Ltd. All rights reserved. * Corresponding author. Bank of France, Financial Stability Directorate, code 35-1537, 31 rue Croix des Petits Champs, 75001 Paris, France. Tel.: þ33142924292; fax: þ33142924867. E-mail addresses: virginie.coudert@banque-france.fr (V. Coudert), valerie.mignon@u-paris10.fr (V. Mignon). Contents lists available at SciVerse ScienceDirect Journal of International Money and Finance journal homepage: www.elsevier.com/locate/jimf 0261-5606/$ – see front matter Ó 2012 Elsevier Ltd. All rights reserved. doi:10.1016/j.jimonfin.2012.05.025 Journal of International Money and Finance 32 (2013) 491–511