Carry Trades and Currency Crashes

36 Pages Posted: 19 Jul 2012 Last revised: 1 Apr 2015

Markus K. Brunnermeier

Princeton University - Department of Economics

Stefan Nagel

University of Michigan, Stephen M. Ross School of Business; University of Michigan Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research

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 K. 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 Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

University of Michigan Department of Economics

Lorch Hall
Ann Arbor, MI 48109
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
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 )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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