Currency Carry Trade and Bank's Foreign Exchange Risk Management

Abstract

The role of the market makers is crucial in determining the foreign exchange risk premium in currency carry trade. A typical market maker of foreign exchange is a highly leveraged commercial bank or investment bank. I derive a model of foreign exchange risk premium from the perspective of a market maker, in which the required foreign exchange risk premium is proportional to the volatility of foreign exchange rate, the net foreign exchange exposure, and the financial leverage. The financial leverage amplifies small changes in net foreign exposure and volatility into large changes in the risk premium. This amplifier effect offers an explanation to the foreign exchange risk premium puzzle. I use this model to examine the negative interest rate differential between Japan and the U.S. in the 1990s.

Keywords: Currency carry trade, Foreign exchange risk management, Leverage, Market maker, Mean-variance optimization, Forward premium puzzle

JEL Classification: F31, F30