Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia

2015 Financial Management Association Annual Meeting; Orlando, FL, US.

2015 European Financial Management Association Annual Meeting; Amsterdam, Netherlands.

64 Pages Posted: 30 Jun 2013 Last revised: 22 Jun 2016

See all articles by Huichou Huang

Huichou Huang

City University of Hong Kong

Ronald MacDonald

University of Glasgow - Adam Smith Business School

Date Written: April 23, 2015

Abstract

In this paper we derive the measure of position-unwinding risk of currency carry trade portfolios from the currency option pricing model. The position-unwinding likelihood indicator is in nature driven by interest rate differential and currency volatility, and highly correlated with global currency skewness risk. We show that high interest-rate currencies are exposed to higher position-unwinding risk than low interest-rate currencies. We then provide a framework that decomposes carry trade payoffs into sovereign credit premium, interest rate differential, and expected exchange rate depreciation (overshooting) upon default components to analyze currency risk premia. We investigate the sovereign CDS spreads as the proxy for solvency of a state and find that high interest-rate currencies load up positively on sovereign default risk while low interest-rate currencies provide a hedge against it. Sovereign credit premia, as the dominant (country-specific) fundamental risk that drives market volatility (global contagion channel), together with position-unwinding likelihood indicator as the market risk sentiment, captures over 90% of cross-sectional variations of carry trade excess returns. In this context, the forward premium puzzle can be understood as a composite story of sovereign credit premia, global liquidity imbalances and reversal. We further reveal that sovereign default risk also explains large proportions of the cross sections of currency momentum (over 65%) and volatility risk premium (over 80%) portfolios.

Keywords: Carry Trades, Position-Unwinding Risk, Sovereign CDS Spreads, Currency Options, Forward Premium Puzzle

JEL Classification: F31, F37, G12, G13, G15

Suggested Citation

Huang, Huichou and MacDonald, Ronald, Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia (April 23, 2015). 2015 Financial Management Association Annual Meeting; Orlando, FL, US. . Available at SSRN: https://ssrn.com/abstract=2287287 or http://dx.doi.org/10.2139/ssrn.2287287

Huichou Huang (Contact Author)

City University of Hong Kong

Global Research Unit (GRU), College of Business
Department of Economics & Finanace
Hong Kong
China

Ronald MacDonald

University of Glasgow - Adam Smith Business School ( email )

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