Post by Huichou Huang on Aug 5, 2013 6:30:36 GMT 4
Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia
Huichou Huang
University of Glasgow - Adam Smith Business School
Ronald MacDonald
University of Glasgow - Adam Smith Business School
January 28, 2013
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.
papers.ssrn.com/sol3/papers.cfm?abstract_id=2287287