Factor/Style Investing

Carry Trades and Currency Crashes

Topics - Factor/Style Investing Carry Currencies Global Macro

${ numberSection } ${ text }
Carry Trades and Currency Crashes

NBER Paper

This paper provides evidence of a strong link between currency carry and currency crash risk: investing in high-interest-rate currencies while borrowing in low-interest-rate currencies delivers negatively skewed returns. We document that speculators invest in high‐carry currencies and argue that currency crashes are linked to the sudden unwinding of these carry trades.

Consistent with models in which the erosion of capital increases insurance premia, we find that the price of protecting against a crash in the aftermath of one increases despite the fact that a subsequent crash is less likely. Further, we document that currency crashes are positively correlated with increases in implied stock market volatility VIX and the TED spread, indicators of funding illiquidity, among other things. This could be the outcome of a setting in which higher volatility leads to lower available speculator capital due to higher margins and capital requirements, inducing traders to cut back on their carry trade activities.

Moreover, we find that a higher VIX predicts higher carry returns going forward and that controlling for this effect reduces the FX return predictability of interest rates, that is, it helps resolve the uncovered interest-rate parity (UIP) violation. Finally, our finding that currencies with similar interest rates move with one another, controlling for other effects, further suggests that carry trades affects exchange rate movements.

Overall, our results are consistent with the view that macroeconomic fundamentals determine which currencies have high and low interest rates and the long‐run currency levels, while illiquidity and capital immobility lead to short‐run currency underreaction to changes in fundamentals and occasional currency crashes due to liquidity crises.

This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. Diversification does not eliminate the risk of experiencing investment losses. 

This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.

The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.