Carry trade and return crash risk

Mouhamadou Sy and Hamidreza Tabarraei
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Mouhamadou Sy: PSE - Paris School of Economics - UP1 - Université Paris 1 Panthéon-Sorbonne - ENS-PSL - École normale supérieure - Paris - PSL - Université Paris Sciences et Lettres - EHESS - École des hautes études en sciences sociales - ENPC - École nationale des ponts et chaussées - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement, PJSE - Paris-Jourdan Sciences Economiques - ENS-PSL - École normale supérieure - Paris - PSL - Université Paris Sciences et Lettres - EHESS - École des hautes études en sciences sociales - ENPC - École nationale des ponts et chaussées - CNRS - Centre National de la Recherche Scientifique
Hamidreza Tabarraei: PSE - Paris School of Economics - UP1 - Université Paris 1 Panthéon-Sorbonne - ENS-PSL - École normale supérieure - Paris - PSL - Université Paris Sciences et Lettres - EHESS - École des hautes études en sciences sociales - ENPC - École nationale des ponts et chaussées - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement, PJSE - Paris-Jourdan Sciences Economiques - ENS-PSL - École normale supérieure - Paris - PSL - Université Paris Sciences et Lettres - EHESS - École des hautes études en sciences sociales - ENPC - École nationale des ponts et chaussées - CNRS - Centre National de la Recherche Scientifique

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Abstract: We build two leveraged and non-leveraged strategies for carry trading. In the non-leveraged carry trade we show that the Sharpe ratio as a proxy for profitability has a concave form with respect to the interest rate differentials. Our model predicts the concavity of the Sharpe ratio and data confirm it as well. However, high interest rate currencies have greater currency crash risk exposure and this is investigated through skewness and kurtosis of 9 most used currencies against Japanese yen. Skewness has a decreasing relationship and kurtosis an increasing relative to the interest rate differentials. We also simulate the positive shocks to the interest rates and negative shock to exchange rates skewness and we study the response of profit. Finally for the leveraged strategy, we show whenever the volatility of the funding currency is low and its covariance with the target currency is large enough, the trader should increase its short-selling position.

Keywords: exchange rate risk premium; crash risk; carry trade; Sharpe ratio (search for similar items in EconPapers)
Date: 2009-03
Note: View the original document on HAL open archive server: https://shs.hal.science/halshs-00566828v1
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