This paper proved a strong relationship between currency carry and currency crash risk, that is, exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed, which means investing in high interest rate currencies while borrowing in low interest rate currencies, delivers negatively skewed returns.
The Brunnermeier, Nagel and Pedersen (BNP)’s paper discussed seven results of their findings. These results are consistent with the view that macroeconomic fundamentals determine which currencies have high and low interest rates and the long-run currency levels, while illiquidity and capital immobility lead to short-run currency under reaction to changes in fundamentals and occasional currency crashed due to liquidity crises.
Firstly, they summarised statistics and simple cross-sectional evidence. They prove a clear negative cross-sectional correlation between skewness and the average interest rate differential from the currency-by-currency perspective. This negative correlation between interest rate differentials and skewness shows that carry trades are exposed to negative skewness. From the portfolio perspective, the carry trade portfolio is profitable on average but has crash risk and fat tails which can be showed from the large Sharpe ratios, negative skewness, and positive excess kurtosis. As for carry trade portfolio, because of currency crashed are correlated across different countries and depend on interest rate differentials, the skewness of carry trade portfolio cannot easily be diversified away. This correlation could be driven by exposure to common risk factors, such as liquidity risk.
Second, BNP’s paper shows that there is a link between interest rate differential and currency traders and crash risk. The result was demonstrated that, currency with high interest rate differentials having predictably high returns. When the study looks at the conditional skewness, the negative conditional skewness can be...