Carry trade and return crash risk

Pre-print, Working paper: We build two leveraged and non-leveraged strategies for carry trading. In the non-leveraged carry trade we show that the Sharpe ratio as a proxy for profitability has a concave form with respect to the interest rate differentials. Our model predicts the concavity of the Sharpe ratio and data confirm it as well. However, high interest rate currencies have greater currency crash risk exposure and this is investigated through skewness and kurtosis of 9 most used currencies against Japanese yen. Skewness has a decreasing relationship and kurtosis an increasing relative to the interest rate differentials. We also simulate the positive shocks to the interest rates and negative shock to exchange rates skewness and we study the response of profit. Finally for the leveraged strategy, we show whenever the volatility of the funding currency is low and its covariance with the target currency is large enough, the trader should increase its short-selling position.

Author(s)

Mouhamadou Sy, Hamidreza Tabarraei

Date of publication
  • 2009
Keywords JEL
E44 F31 G12
Keywords
  • Exchange rate risk premium
  • Crash risk
  • Carry trade
  • Sharpe ratio
Internal reference
  • PSE Working Papers n°2009-14
Version
  • 1