Downside Market Risk of Carry Trades

Abstract

I propose a new factor – the global downside market factor – to explain high returns to carry trades. I show that carry trades have high downside market risk, i.e. they crash systematically in the worst states of the world when the global stock market plunges or when a disaster occurs. The downside market factor explains the returns to currency portfolios sorted by the forward discount better than other factors previously proposed in the literature. GMM estimates of the downside beta premium are similar in the currency and stock markets, statistically significant and close to their theoretical value. High returns to carry trades are fair compensation for their high downside market risk.

Keywords: carry trades, currency risk, downside risk, downside beta, disaster risk

JEL Classification: G12, G15, F31