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Carry Trade and Currency Crash Risk

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  • Mavus Kutuk, Merve
  • van Wijnbergen, Sweder

Abstract

This paper examines the role of currency crash risk in explaining the persistent profitability of carry trades. Focusing on the US Dollar–Turkish Lira market, we construct three forward-looking measures of crash risk: risk reversals, crash probabilities from option-implied distributions, and jump risk from a jump-diffusion model. Using survey-based exchange rate expectations, we separate ex ante carry premia from ex post surprises. Our results show that higher crash risk significantly increases expected returns, indicating that investors demand compensation for bearing such risk rather than arbitraging away mispricing. Shapley decomposition attributes over 20\% of the explained variance in expected carry returns to crash risk, while balance sheet constraints and global risk aversion further reinforce premia. A comparison of hedged and unhedged strategies reveals that 46–77\% of carry returns reflect compensation for crash exposure.

Suggested Citation

  • Mavus Kutuk, Merve & van Wijnbergen, Sweder, 2025. "Carry Trade and Currency Crash Risk," CEPR Discussion Papers 20745, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:20745
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    File URL: https://cepr.org/publications/DP20745
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    JEL classification:

    • F13 - International Economics - - Trade - - - Trade Policy; International Trade Organizations
    • G01 - Financial Economics - - General - - - Financial Crises
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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