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Carry Trades and Currency Crashes

In: NBER Macroeconomics Annual 2008, Volume 23

  • Markus K. Brunnermeier
  • Stefan Nagel
  • Lasse H. Pedersen

This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interest-rate puzzle. Carry-trade losses reduce future crash risk, but increase the price of crash risk. We also document excess co-movement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.

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This chapter was published in:
  • Daron Acemoglu & Kenneth Rogoff & Michael Woodford, 2009. "NBER Macroeconomics Annual 2008, Volume 23," NBER Books, National Bureau of Economic Research, Inc, number acem08-1, July.
  • This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 7286.
    Handle: RePEc:nbr:nberch:7286
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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