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Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia

Huang, Huichou and MacDonald, Ronald (2012): Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia.

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Abstract

This is the first study that employs option pricing model to measure the position-unwinding risk of currency carry trade portfolios, which covers moment information as the proxy for crash risk. We show that high interest-rate currencies are exposed to higher position-unwinding risk than low interest-rate currencies. I also investigate the sovereign CDS spreads as the proxy for countries' credit conditions and find that high interest rate currencies load up positively on sovereign default risk while low interest rate currencies provide a hedge against it. Sovereign credit premia as the dominant economic fundamental risk, together with position-unwinding likelihood indicator as the market risk (non-neutrality) sentiment, captures over 90% cross-sectional variations of carry trade excess returns. I identify sovereign credit risk as the impulsive country-specific risk that drives market volatility, and also the global contagion channels. Then I propose an alternative carry trade strategy that is immunized from crash risk, and a composite story of sovereign credit premia, global liquidity imbalances and liquidity reversal/spiral for explaining the forward premium puzzle.

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