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

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. I 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.JEL classification: F31, F37, G12, G13, G15.

Global Currency Misalignments, Crash Sensitivity, and Downside Insurance Costs

“…The currency risk premia are the compensations for dynamic business cycle risk. Huang and MacDonald (2013) show that the excess returns of currency carry trades can be understood from the perspective of sovereign credit premia and their results are robust to the alternative measure of sovereign default risk implied in government bonds. However, this is not a full story.…”

“…Therefore, we reasonably conjecture that currency risk premia originate from their misalignments, as equilibrium exchange rates are the composite indicators of the competitiveness of the states and exchange rate misalignments reflect the sustainability of the states. We find currency misalignment risk explains over 97% of the cross-sectional excess returns of carry trades and both currency carry and misalignment portfolios trade on the position-unwinding likelihood indicator (Huang and MacDonald, 2013) that explores the probability of the Uncovered Interest Rate Parity (UIP) to hold in the option pricing model, so do other currency investment strategies studied in this paper.…”

“…is the conditional expectation operator under risk-neutral measure P. We follow Bollerslev, Tauchen, and Zhou (2009) to adopt the lagged realized volatility, and continue to use our calculations of realized moments in Huang and MacDonald (2013). By doing this, we are able to observe ex-ante moment risk premia which does not involve any modeling assumption.…”

“…In the horse race of currency crash risk with GV I, neither of these two factors dominates in the cross-sectional regressions. REER misalignment risk factor is the best proxy for currency risk premia in carry trades over the sample period in terms of cross-sectional R 2 and statistical significance of factor price(see Huang and MacDonald, 2013, for the horse races of other candidate risk factors). In the 35 In a two-factor linear model of GDR + GV I, the risk exposures to GV I exhibit a monotonic pattern and the factor price of GV I is statistically significant (−0.326% with a standard error of 0.250).…”

“…It explains over 97% of the cross-sectional excess returns and dominates other candidate factors, including volatility and liquidity risk. Both currency carry and misalignment portfolios trade on the position-likelihood indicator (Huang and MacDonald, 2013) that explores the probability of the Uncovered Interest Rate Parity (UIP) to hold in the option pricing model. To examine the crash story of currency risk premia, we employ copula method to capture the tail sensitivity (CS) of currencies to the global market, and compute the moment risk premia by model-free approach using volatility risk premia as the proxy for downside insurance costs (DI).…”