Carry Trades and Currency Crashes

Markus K. Brunnermeier (), Stefan Nagel and Lasse Heje Pedersen

No 14473, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E44 F3 F31 G12 (search for similar items in EconPapers)
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Chapter: Carry Trades and Currency Crashes (2008)
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