Carry Trade Fundamentals and the Financial Crisis

Vistesen, Claus (2009): Carry Trade Fundamentals and the Financial Crisis.

Abstract

This paper takes the form of an event study surrounding the current financial crisis. It proposes a theoretical relationship which can be used to model traditional carry trade crosses on a daily return basis as a negative function of equity returns and a positive function of market volatility. In order to test this theory, an Arbitrage Pricing Theory framework is adopted which the factor betas of carry trade crosses with respect to equity returns and market volatility. It is shown how the variation in the currency crosses explained by the functional relationship as well as the estimated factor betas have increased significantly in relation to the financial crisis. The results indicate that low yielding currencies (the JPY and CHF) can be successfully modeled as a negative function of equity returns and a positive function of volatility in the market. The results furthermore underpin studies that have shown how carry trading activity is highly sensitive towards sudden sparks of volatility and risk aversion, and thus how carry trade fundamentals are time varying.

• Item Type: MPRA Paper
• Language: English
• Keywords: International finance; carry trading; financial crisis; currencies
• Subjects: F - International Economics > F3 - International Finance; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets; F - International Economics > F3 - International Finance > F31 - Foreign Exchange

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