Research Seminar by Victoria Dobrynskaya (ICEF-HSE, LSE): "How risky are carry trades?"

Thursday, December 10 ICEF held the regular Research seminar.
Presenter: Victoria Dobrynskaya (ICEF-HSE, LSE)
Topic: "How risky are carry trades?"

Abstract: Carry trades (borrowing in low-interest currencies and investing in high-interest currencies) consistently generate high excess returns with high Sharp ratios, but are subject to crash risk. I take a closer look at the link between the carry trade returns and the stock market to understand the risks involved in the carry trade activity and to determine when and why the crashes happen. Every period, I sort the currencies of developed and emerging economies by their interest rate differential with the US T-bill rate and form portfolios to diversify the idiosyncratic risk. I find a strong negative relationship between portfolio returns and skewness of exchange rate changes. In fact, skewness and coskewness with the stock market have a much greater explanatory power than consumption and stock market betas. But separating the market beta into upside and downside betas improves the validity of CAPM significantly. Downside beta has a much greater explanatory power than upside beta, and it correlates almost perfectly with coskewness. This means that carry trades crash exactly in the worst states of the world, when the stock market goes down. I also find that country sovereign risk proxies well for the downside beta and skewness. Therefore, there is unwinding of carry trades and a ‘flight to quality’ when the stock market plunges, and the low-interest currencies serve as a ‘safe heaven’. Finally, I detect a regime shift around the turn of the century: in 90s skewness and beta were unrelated and only skewness was priced, but in 2000s there is a very strong relation between skewness and beta and much greater explanatory power of beta. The growing volume of carry activities might have contributed to the closer link between the currency and the stock markets.

Venue: Pokrovski Bulvar, 11, Room Zh-822

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