Munich Personal RePEc Archive

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.

This is the latest version of this item.

[img]
Preview
PDF
MPRA_paper_48764.pdf

Download (1MB) | Preview

Abstract

This is the first study that employs option pricing model to measure the position-unwinding risk of currency carry trade portfolios, which well covers the moment information. We show that high interest-rate currencies are exposed to higher position-unwinding risk than low interest-rate currencies. We 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 (nonneutrality) sentiment, captures over 90% cross-sectional variations of carry trade excess returns. We identify sovereign credit risk as the impulsive country-specific risk that drives market volatility, and also its global contagion channels. Then We propose an alternative carry trade strategy 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.

Available Versions of this Item

UB_LMU-Logo
MPRA is a RePEc service hosted by
the Munich University Library in Germany.