Carry Trade, Forward Premium Puzzle and Currency Crisis
AbstractRecent many empirical studies have argued that currency carry trade have been a driving force behind exchange rate movements, and have explained the latest financial crisis of 2007-2009 in terms of a sudden, massive reversal of carry trade positions. The aim of this paper is to provide one potential theoretical explanation for questions why currency carry trade becomes profitable, and why a sudden unwinding of carry trade is caused. We propose a new behavioral model of currency bubbles and crashes. We consider that investors trade two currencies: the domestic currency, and the foreign currency. Investors are divided into two groups, the rational investors and the carry traders. The rational investors maximize their expected utility of their wealth in the next period. Carry traders maximize their random utility of binary choice: investing the domestic currency or investing the foreign currency. We demonstrate that carry-traders’ herd behavior, which follows the behavior getting a majority, gives cause to a currency bubble, and their carry trading prolongs bubble. However, depreciation of funding currency slows down as the carry-trader’s behavior approaches to a stationary state, so that the return on carry trade predicted by carry traders begins to decrease in the second half of bubble. We demonstrate that decreasing the return on carry trade predicted by carry traders lead to currency crash. Our model also gives a plausible explanation on the forward premium puzzle.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 21432.
Date of creation: 10 Mar 2010
Date of revision:
Carry trade; forward premium puzzle; currency crisis; behavioral finance;
Find related papers by JEL classification:
- F31 - International Economics - - International Finance - - - Foreign Exchange
- G01 - Financial Economics - - General - - - Financial Crises
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-03-28 (All new papers)
- NEP-IFN-2010-03-28 (International Finance)
- NEP-UPT-2010-03-28 (Utility Models & Prospect Theory)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2009.
"Carry Trades and Currency Crashes,"
in: NBER Macroeconomics Annual 2008, Volume 23, pages 313-347
National Bureau of Economic Research, Inc.
- Marion Kohler, 2010. "Exchange rates during financial crises," BIS Quarterly Review, Bank for International Settlements, March.
- Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 2007.
"The Returns to Currency Speculation in Emerging Markets,"
NBER Working Papers
12916, National Bureau of Economic Research, Inc.
- Martin Eichenbaum & Craig Burnside & Sergio Rebelo, 2007. "The Returns to Currency Speculation in Emerging Markets," American Economic Review, American Economic Association, vol. 97(2), pages 333-338, May.
- Burnside, A Craig & Eichenbaum, Martin & Rebelo, Sérgio, 2007. "The Returns to Currency Speculation in Emerging Markets," CEPR Discussion Papers 6148, C.E.P.R. Discussion Papers.
- Charles Engel, 1995.
"The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence,"
NBER Working Papers
5312, National Bureau of Economic Research, Inc.
- Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
- Michael Melvin & Mark P. Taylor, 2009.
"The Crisis in the Foreign Exchange Market,"
CESifo Working Paper Series
2707, CESifo Group Munich.
- John Cairns & Corrinne Ho & Robert McCauley, 2007. "Exchange rates and global volatility: implications for Asia-Pacific currencies," BIS Quarterly Review, Bank for International Settlements, March.
- Lintner, John, 1969. "The Aggregation of Investor's Diverse Judgments and Preferences in Purely Competitive Security Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 4(04), pages 347-400, December.
- Gabriele Galati & Alexandra Heath & Patrick McGuire, 2007. "Evidence of carry trade activity," BIS Quarterly Review, Bank for International Settlements, September.
- Kaizoji, Taisei (firstname.lastname@example.org), 2010.
"A behavioral model of bubbles and crashes,"
35655, University Library of Munich, Germany.
- Jacob Gyntelberg & Eli M Remolona, 2007. "Risk in carry trades: a look at target currencies in Asia and the Pacific," BIS Quarterly Review, Bank for International Settlements, December.
- Joseph E. Gagnon & Alain P. Chaboud, 2007. "What can the data tell us about carry trades in Japanese yen?," International Finance Discussion Papers 899, Board of Governors of the Federal Reserve System (U.S.).
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Ekkehart Schlicht).
If references are entirely missing, you can add them using this form.