This paper documents that carry traders are subject to crash risk; that is, 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 rates. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.
All Science Journal Classification (ASJC) codes
- Economics and Econometrics