Carry Trade Fundamentals and the Financial Crisis 2007-2010

Vistesen, Claus (2009): Carry Trade Fundamentals and the Financial Crisis 2007-2010.

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 is used to estimate 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

References

Alexander, J. Gordon & Chervany, L. Norman (1980) - On the Estimation and Stability of Beta, The Journal of Financial and Quantitative Analysis vol. 15 no. 1 (march 1980) pp. 123-137

Bilson, John (1980) - The Speculative Efficiency Hypothesis, Journal of Business vol. 54 (June) pp. 433-451

Brière and Drut (2009) - The Revenge of Purchasing Power Parity on Carry Trades During Crises, CEB Working Paper No. 09/013 Feb. 2009

Brunnermeier M., Nagel S. and Pedersen L. (2008) - "Carry Trades and Currency Crashes", NBER Working Paper No. 14473, November

Chinn, D. Menzie & Meredith, Guy (2004) - Monetary Policy and Long Run Horizon Uncovered Interest Parity, IMF Staff Paper vol. 51 no 3

Chow, C. Gregory (1960) - Tests of Equality Between Sets of Coefficients in Two Linear Regressions, Econometrica vol. 28 no. 3 (1960) pp. 591-605

Christiansen, Charlotte; Ranaldo, Angelo and Söderlind, Paul (2009) - The Time-Varying Systematic Risk of Carry Trade Strategies, CREATES Research Paper 2009-15

Corcoran, Aidan (2009) - The Determinants of Carry Trade Risk Premia, IIS discussion paper no. 287

De Santis, A. Roberto & Sarno, Lucio (2008) - Assesing the Benefits of International Portfolio Diversification in Bonds and Stocks, ECB Working Paper no. 883 (March 2008)

Fama E. & MacBeth J (1973) - Risk, Return, and Equilibrium: Empirical Tests, Journal of Political Economy, Vol. 81, Issue 3, pp. 607-636.

Farhi, E. and Gabaix, X. (2008) - Rare disasters and exchange rates, Working paper, Harvard University and NYU Stern.

Gagnon, Joseph E & Chaboud, Alain (2007) - What can the data tell us about carry trades in Japanese yen, FRB International Finance Discussion Paper No. 899

Granger, C. W. J. (1969) - Investigating Causal Relations by Econometric Models and Cross Spectral Methods, Econometrica (July 1969) pp. 424-438

Greene, William H. (2003) - Econometric Analysis, 5th edition Prentice Hall

Gujarati, Damodar N. (2003) - Basic Econometrics 4th edition McGraw Hill

Hau, H, & H, Rey (2006) - Exchange Rates, Equity Prices, and Capital Flows, Review of Financial Studies 19; 273-317.

IMF (2009) - World Economic Outlook 2009, IMF publication

Kohler D. (2007) - Carry Trades: Betting Against Safe Haven, University of St.Gallen Discussion Paper no. 2007-12

Longworth, David (1981) - Testing the Efficiency of the Canadian-U.S. Exchange Market Under the Assumption of No Risk Premium, Journal of Finance, Vol. 36, No. 1, pp. 43-9

Meese, Richard (1989) - Empirical Assessment of Foreign Currency Risk Premiums," in Financial Risk: Theory, Evidence, and Implications, ed. by Courtenay Stone (Boston: Kluwer Academic Publications)

Olmo, Jose & Pilbeam, Keith (2008) - The Profitability of Carry Trades, Annals of Finance 11 April 2008

Orléan A. (1999) - Le pouvoir de la finance, Odile Jacob Editions

Plantin G. & Shin. H.S. (2008) - Carry Trades and Speculative Dynamics, available at SSRN: http://ssrn.com/abstract=898412

Rogoff, Kenneth (1983) - Empirical Exchange Rate Models of the Seventies, Journal of International Economics, Vol. 14 (February), pp. 3-24

Ross, Stephen (1976) - The arbitrage theory of capital asset pricing. Journal of Economic Theory 13 (3): 341-360.

White, Stanley and Kim-Mai Cutler (2008) - Yen Falls as Asian Stock Gains Boost Confidence in Carry Trades, 16th June 2008 Bloomberg News Article.

Zimmermann H. et al. (2003) - Global Asset Allocation: New Methods and Applications (chapter 3), John Wiley and Sons inc