Carry Trades and Currency Crashes

36 Pages Posted: 19 Jul 2012 Last revised: 20 Jul 2022

See all articles by Markus K. Brunnermeier

Markus K. Brunnermeier

Princeton University - Department of Economics

Stefan Nagel

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research; CESifo (Center for Economic Studies and Ifo Institute)

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Date Written: November 2008

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.

Suggested Citation

Brunnermeier, Markus Konrad and Nagel, Stefan and Pedersen, Lasse Heje, Carry Trades and Currency Crashes (November 2008). NBER Working Paper No. w14473, Available at SSRN: https://ssrn.com/abstract=2112805

Markus Konrad Brunnermeier (Contact Author)

Princeton University - Department of Economics ( email )

Bendheim Center for Finance
Princeton, NJ
United States
609-258-4050 (Phone)
609-258-0771 (Fax)

HOME PAGE: http://www.princeton.edu/¡­markus

Stefan Nagel

University of Chicago - Booth School of Business ( email )

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Chicago, IL 60637
United States

National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research ( email )

London
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CESifo (Center for Economic Studies and Ifo Institute) ( email )

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Germany

Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

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Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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