NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Carry Trades and Currency Crashes

Markus K. Brunnermeier, Stefan Nagel, Lasse H. Pedersen

NBER Working Paper No. 14473
Issued in November 2008
NBER Program(s):   AP   EFG   IFM   ME

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

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This paper was revised on December 16, 2013

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Document Object Identifier (DOI): 10.3386/w14473

Published: Carry Trades and Currency Crashes, Markus K. Brunnermeier, Stefan Nagel, Lasse H. Pedersen. in NBER Macroeconomics Annual 2008, Volume 23, Acemoglu, Rogoff, and Woodford. 2009

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