Working Paper: NBER ID: w14473
Authors: Markus K. Brunnermeier; Stefan Nagel; Lasse H. Pedersen
Abstract: This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interest-rate puzzle. Carry-trade losses reduce future crash risk, but increase the price of crash risk. We also document excess co-movement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.
Keywords: carry trade; currency crash; liquidity; exchange rates; speculators
JEL Codes: E44; F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| unwinding of carry trades (F32) | sudden exchange rate movements (F31) |
| positive interest rate differentials (E43) | negative conditional skewness of exchange rate movements (F31) |
| carry trade losses (F65) | reduction in future crash risk (R48) |
| carry trade losses (F65) | increase in price of crash risk (R48) |
| increase in VIX (G17) | higher returns for investment currencies (G15) |
| increase in VIX (G17) | lower returns for funding currencies (G15) |
| currencies with similar interest rates (F31) | co-move (J62) |