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Carry Trades and Currency Crashes

  • 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14473.

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Date of creation: Nov 2008
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Publication status: published as Carry Trades and Currency Crashes , Markus K. Brunnermeier, Stefan Nagel, Lasse H. Pedersen. in NBER Macroeconomics Annual 2008, Volume 23 , Acemoglu, Rogoff, and Woodford. 2009
Handle: RePEc:nbr:nberwo:14473
Note: AP EFG IFM ME
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