36 Pages Posted: 19 Jul 2012
Date Written: November 2008
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: 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
By Andrew Ang
By Meb Faber