Carry Trades and Currency Crashes
I’ve noticed quite a stir in the blogosphere around Roubini’s latest article, ” The Mother Of All Carry Trades Faces An Inevitable Bust” . So I’ve decided to post a relevant paper on Carry Trade & Curency crashes.
Click Here To Learn About Carry Trades & Currency Crashes
Introduction (Via Princeton)
This paper studies crash risk of currencies for funding‐constrained speculators in an attempt to shed new light on the major currency puzzles. Our starting point is the currency carry trade, which consists of selling low interest rate currencies—“funding currencies”—and investing in high interest rate currencies—“investment currencies.” While the uncovered interest rate parity (UIP) hypothesizes that the carry gain due to the interest rate differential is offset by a commensurate depreciation of the investment currency, empirically the reverse holds, namely, the investment currency appreciates a little on average, albeit with a low predictive R2 (see, e.g., Fama 1984). This violation of the UIP—often referred to as the “forward premium puzzle”—is precisely what makes the carry trade profitable on average. Another puzzling feature of currencies is that dramatic exchange rate movements occasionally happen without fundamental news announcements, for example, the large depreciation of the U.S. dollar against the Japanese yen on October 7 and 8, 1998, depicted in figure 1.1 This reflects the broader phenomenon that many abrupt asset price movements cannot be attributed to a fundamental news events, as documented by Cutler and Summers (1989) and Fair (2002).
Most Fascinating Paragraph (Via Princeton)
We document that speculators invest in high‐carry currencies and argue that currency crashes are linked to the sudden Carry Trades and Currency Crashes 341 unwinding of these carry trades. Consistent with models in which the erosion of capital increases insurance premia, we find that the price of protecting against a crash in the aftermath of one increases despite the fact that a subsequent crash is less likely. Further, we document that currency crashes are positively correlated with increases in implied stock market volatility VIX and the TED spread, indicators of funding illiquidity, among other things.
