Economics, Econometrics and Finance
4 years ago

Currency carry trades linked to market crashes due to funding liquidity constraints.

Carry Trades and Currency Crashes
Markus K. Brunnermeier, Stefan Nagel, Lasse Heje Pedersen

Paper Summary

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Carry traders who invest in high-interest-rate currencies are at risk of sudden losses due to exchange rate movements. These losses can lead to crashes in the currency market. The risk of crashes is higher when funding liquidity decreases. Measures of funding liquidity can predict exchange rate movements. Losses from carry trades can reduce future crash risk but also increase the price of crash risk. Currencies with similar interest rates tend to move together. Carry traders can face constraints on accessing funding liquidity.