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 payo¤s which are on average large and uncorrelated with tra-
ditional risk factors. We investigate whether these payo¤s re‡ect a peso problem. We
argue that they do. We reach this conclusion by analyzing the payo¤s 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.