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Carry Trade and Currency Crash Risk

Author

Listed:
  • Merve Kutuk

    (CPB Netherlands Bureau)

  • Sweder van Wijnbergen

    (University of Amsterdam)

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

  • Merve Kutuk & Sweder van Wijnbergen, 2025. "Carry Trade and Currency Crash Risk," Tinbergen Institute Discussion Papers 25-058/IV, Tinbergen Institute.
    • Handle: RePEc:tin:wpaper:20250058
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    References listed on IDEAS

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    Keywords

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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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