Safe Asset Carry Trade (G1, E4)
AbstractInvestors pay a "convenience premium" for the safety and liquidity benefits provided by near-money or safe assets. This convenience premium varies across time and securities. For instance, U.S. Treasuries have a lower yield than otherwise equivalent safe assets. While the temporal and cross-sectional variation in the prices of safe assets is well documented in the literature, our understanding of their asset pricing implications is still very limited. We provide the first systematic asset pricing analysis of one important category of safe assets, the repurchase agreement (repo).
We find that heterogeneity in repo rates allows for a remunerative carry trade. This carry trade involves a long position in "less expensive" safe assets and a simultaneous short position in their "more expensive" counterparts. The return on this investment strategy, our carry factor, exhibits time-variation, which points toward time-dependent cross-sectional differences among safe assets. A standard, no-arbitrage model with two risk factors, a market factor and a carry factor, is able to explain the price of safe assets: While the market factor determines the level of short-term interest rates, the carry factor accounts for their cross-sectional dispersion. From the perspective of the safe asset literature, our carry factor reflects a portfolio-based convenience premium differential and is explained by three main factors: the safety premium, the liquidity premium, and the opportunity cost of holding money.
Our analysis contributes to three strands of the literature. First, we contribute to the asset pricing literature by introducing a new focus on short-term interest rates. Second, our analysis contributes to the literature on the dispersion in short-term interest rates by highlighting that heterogeneity in repo rates allows for a remunerative carry trade. Third, we add to the growing literature on safe assets shortages and their macroeconomic and financial stability implications by explaining the existence of our carry factor from a safe asset perspective.