CARRY TRADE AND CURRENCY CRASHES

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Carry Trades and Currency Crashes
Markus K. Brunnermeier, Princeton University, NBER, and CEPR
Stefan Nagel, Stanford University and NBER
Lasse H. Pedersen, New York University, NBER, and CEPR

I. Introduction
This paper studies crash risk of currencies for funding‐constrained speculators in an attempt to shed new light on the major currency puzzles. Our starting point is the currency carry trade, which consists of selling low interest rate currencies—“funding currencies”—and investing in high interest rate currencies—“investment currencies.” While the uncovered interest rate parity (UIP) hypothesizes that the carry gain due to the interest rate differential is offset by a commensurate depreciation of the investment currency, empirically the reverse holds, namely, the investment currency appreciates a little on average, albeit with a low predictive R2 (see, e.g., Fama 1984). This violation of the UIP—often referred to as the “forward premium puzzle”—is precisely what makes the carry trade profitable on average. Another puzzling feature of currencies is that dramatic exchange rate movements occasionally happen without fundamental news announcements, for example, the large depreciation of the U.S. dollar against the Japanese yen on October 7 and 8,
1998, depicted in figure 1.1 This reflects the broader phenomenon that many abrupt asset price movements cannot be attributed to a fundamental news events, as documented by Cutler and Summers (1989) and Fair
(2002).
We conjecture that sudden exchange rate moves unrelated to news can be due to the unwinding of carry trades when speculators near funding constraints. This idea is consistent with our findings that (i) investment currencies are subject to crash risk, that is, positive interest rate differentials are associated with negative conditional skewness of exchange rate movements; (ii) the carry, that is, interest rate differential, is associated with positive speculator net positions in

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