Carry Trade and Currency Crash Risk

Merve Kutuk and Sweder van Wijnbergen
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Merve Kutuk: CPB Netherlands Bureau
Sweder van Wijnbergen: University of Amsterdam

No 25-058/IV, Tinbergen Institute Discussion Papers from Tinbergen Institute

Abstract: This paper examines the role of currency crash risk in explaining the persistent profitability of carry trades. Focusing on the US Dollar–Turkish Lira market, we construct three forward-looking measures of crash risk: risk reversals, crash probabilities from option-implied distributions, and jump risk from a jump-diffusion model. Using survey-based exchange rate expectations, we separate ex ante carry premia from ex post surprises. Our results show that higher crash risk significantly increases expected returns, indicating that investors demand compensation for bearing such risk rather than arbitraging away mispricing. Shapley decomposition attributes over 20\% of the explained variance in expected carry returns to crash risk, while balance sheet constraints and global risk aversion further reinforce premia. A comparison of hedged and unhedged strategies reveals that 46–77\% of carry returns reflect compensation for crash exposure.

Keywords: Exchangerates; currencycrashrisk; mispricing; dollarexchangerate; bankcur- rency mismatches (search for similar items in EconPapers)
JEL-codes: F13 G01 G10 G12 G15 (search for similar items in EconPapers)
Date: 2025-10-10
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Persistent link: https://EconPapers.repec.org/RePEc:tin:wpaper:20250058

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