Carry Trades and Currency Crashes
Markus K. Brunnermeier, Princeton University, NBER, and CEPR Stefan Nagel, Stanford University and NBER
Lasse H. Pedersen, New York University, NBER, and CEPR
This paper studies crash risk of currencies for funding‐constrained speculators in an attempt to shed new light on the major currency puzzles. Our starting point is the currency carry trade, which consists of selling low interest rate currencies—“funding currencies”—and investing in high interest rate currencies—“investment currencies.” While the uncovered interest rate parity (UIP) hypothesizes that the carry gain due to the interest rate differential is offset by a commensurate depreciation of the investment currency, empirically the reverse holds, namely, the investment currency appreciates a little on average, albeit with a low predictive R2 (see, e.g., Fama 1984). This violation of the UIP—often referred to as the “forward premium puzzle”—is precisely what makes the carry trade profitable on average. Another puzzling feature of currencies is that dramatic exchange rate movements occasionally happen without fundamental news announcements, for example, the large depreciation of the U.S. dollar against the Japanese yen on October 7 and 8, 1998, depicted in figure 1.1 This reflects the broader phenomenon that many abrupt asset price movements cannot be attributed to a fundamental news events, as documented by Cutler and Summers (1989) and Fair (2002).
We conjecture that sudden exchange rate moves unrelated to news can be due to the unwinding of carry trades when speculators near funding constraints. This idea is consistent with our findings that (i) investment currencies are subject to crash risk, that is, positive interest rate differentials are associated with negative conditional skewness of exchange rate movements; (ii) the carry, that is, interest rate differential, is associated with positive speculator net positions in investment currencies; (iii) speculators’ positions increase crash risk; (iv) carry trade © 2009 by the National Bureau of Economic Research. All rights reserved. 978‐0‐226‐00204‐0/2009/2008‐0501$10.00
Brunnermeier, Nagel, and Pedersen
U.S. dollar/Japanese yen exchange rate from 1996 to 2000
losses increase the price of crash risk but lower speculator positions and the probability of a crash; (v) an increase in global risk or risk aversion as measured by the VIX equity‐option implied volatility index coincides with reductions in speculator carry positions (unwind) and carry trade losses; (vi) a higher level of VIX predicts higher returns for investment currencies and lower returns for funding currencies, and controlling for VIX reduces the predictive coefficient for interest rate differentials, thus helping resolve the UIP puzzle; (vii) currencies with similar levels of interest rate comove with each other, controlling for other effects. (viii) More generally, the crash risk we document in this paper may discourage speculators from taking on large enough positions to enforce UIP. Crash risk may thus help explain the empirically well‐documented violation of the UIP.
Our findings share several features of the “liquidity spirals” that arise in the model of Brunnermeier and Pedersen (2009). They show theoretically that securities that speculators invest in have a positive average return and a negative skewness. The positive return is a premium for providing liquidity, and the negative skewness arises from an asymmetric response to fundamental shocks: shocks that lead to speculator losses are amplified when speculators hit funding constraints and unwind their positions, further depressing prices, increasing the funding problems, volatility, and margins, and so on. Conversely, shocks that lead to speculator gains are not amplified. Further, Brunnermeier and Pedersen (2009) show that securities where speculators have long positions will move together, as will...
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