Carry Trades and Tail Risk of Exchange Rates

Ganepola, C., 2016. Carry Trades and Tail Risk of Exchange Rates. Staff Studies, 44(1-2).

43 Pages Posted: 28 Jan 2015 Last revised: 21 Sep 2018

See all articles by Chanaka N. Ganepola

Chanaka N. Ganepola

University of Manchester - Manchester Business School; Central Bank of Sri Lanka

Date Written: January 26, 2015

Abstract

Historically, Carry trades have been a success story for most investor and a major source of funds for emerging economies maintaining higher interest rates. Therefore it’s a timely topic to investigate the risk embedded in such transactions and to what extent the carry trade returns explain the tail risk. Initially, this research estimates the tail index of all the currencies and formulates a unique inverse function for all the currencies in relation to Power laws, with the idea of estimating the respective Value-at-Risk. This research considers twenty five currencies and replicates them in to five portfolios based on the annualised daily return of a weekly forward contract. Trade was executed assuming a U.S. investor, who goes long in a high return portfolio and short in a low return portfolio. Further, this research examines the impact of carry trade returns on the overall tail risk within the context of foreign exchange and interest rate gain in long and short positions of the trade. The results indicate that tail risk cannot be explained effectively by its returns because of its exponential nature. However, I find that tail risk is mostly influenced by the long position of the carry trade. Furthermore, the return of the foreign exchange component appears to have a better explanation on the tail risk compared to the interest rate return. The Value-at-Risk analysis also suggests that the tail risk of overall strategy is influenced by the tail risk of foreign exchange component embedded in the long position of the trade.

Keywords: Tail Risk, Carry Trades

Suggested Citation

Ganepola, Chanaka, Carry Trades and Tail Risk of Exchange Rates (January 26, 2015). Ganepola, C., 2016. Carry Trades and Tail Risk of Exchange Rates. Staff Studies, 44(1-2).. Available at SSRN: https://ssrn.com/abstract=2555805 or http://dx.doi.org/10.2139/ssrn.2555805

Chanaka Ganepola (Contact Author)

University of Manchester - Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom

Central Bank of Sri Lanka ( email )

30, Janadhipathi Mw.
Colombo 01
Sri Lanka

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