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Carry Trade, Forward Premium Puzzle and Currency Crisis

  • Kaizoji, Taisei

Recent 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.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 21432.

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Date of creation: 10 Mar 2010
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Handle: RePEc:pra:mprapa:21432
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  1. 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.
  2. 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.).
  3. Kaizoji, Taisei (kaizoji@icu.ac.jp), 2010. "A Behavioral Model of Bubbles and Crashes," MPRA Paper 20352, University Library of Munich, Germany.
  4. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2008. "Carry Trades and Currency Crashes," NBER Working Papers 14473, National Bureau of Economic Research, Inc.
  5. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sérgio, 2007. "The Returns to Currency Speculation in Emerging Markets," CEPR Discussion Papers 6148, C.E.P.R. Discussion Papers.
  6. 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.
  7. Gabriele Galati & Alexandra Heath & Patrick McGuire, 2007. "Evidence of carry trade activity," BIS Quarterly Review, Bank for International Settlements, September.
  8. Melvin, Michael & Taylor, Mark P, 2009. "The Crisis in the Foreign Exchange Market," CEPR Discussion Papers 7472, C.E.P.R. Discussion Papers.
  9. 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.
  10. 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.
  11. Marion Kohler, 2010. "Exchange rates during financial crises," BIS Quarterly Review, Bank for International Settlements, March.
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