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Carry Trades and Currency Crashes

Author

Listed:
  • Markus K. Brunnermeier

    (Princeton University)

  • Stefan Nagel

    (University of Michigan)

  • Lasse H. Pedersen

    (Copenhagen Business School)

Abstract

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 comovement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.

Suggested Citation

  • Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2008. "Carry Trades and Currency Crashes," Working Papers 2008-1, Princeton University. Economics Department..
  • Handle: RePEc:pri:econom:2008-1
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    More about this item

    Keywords

    Carry Trade; Crash Risk;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F3 - International Economics - - International Finance
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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