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Carry trade and return crash risk

Author

Listed:
  • Mouhamadou Sy

    (PSE - Paris School of Economics, PJSE - Paris-Jourdan Sciences Economiques - ENS Paris - École normale supérieure - Paris - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique)

  • Hamidreza Tabarraei

    (PSE - Paris School of Economics, PJSE - Paris-Jourdan Sciences Economiques - ENS Paris - École normale supérieure - Paris - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique)

Abstract

We build two leveraged and non-leveraged strategies for carry trading. In the non-leveraged carry trade we show that the Sharpe ratio as a proxy for profitability has a concave form with respect to the interest rate differentials. Our model predicts the concavity of the Sharpe ratio and data confirm it as well. However, high interest rate currencies have greater currency crash risk exposure and this is investigated through skewness and kurtosis of 9 most used currencies against Japanese yen. Skewness has a decreasing relationship and kurtosis an increasing relative to the interest rate differentials. We also simulate the positive shocks to the interest rates and negative shock to exchange rates skewness and we study the response of profit. Finally for the leveraged strategy, we show whenever the volatility of the funding currency is low and its covariance with the target currency is large enough, the trader should increase its short-selling position.

Suggested Citation

  • Mouhamadou Sy & Hamidreza Tabarraei, 2009. "Carry trade and return crash risk," PSE Working Papers halshs-00566828, HAL.
  • Handle: RePEc:hal:psewpa:halshs-00566828
    Note: View the original document on HAL open archive server: https://halshs.archives-ouvertes.fr/halshs-00566828
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