5

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 fundingconstrained

speculators in an attempt to shed new light on the major currency puz-
zles. Our starting point is the currency carry trade, which consists of
selling low interest rate currenciesfunding currenciesand invest-
ing in high interest rate currenciesinvestment currencies. While the
uncovered interest rate parity (UIP) hypothesizes that the carry gain
due to the interest rate differential is offset by a commensurate deprecia-
tion 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 UIPoften re-
ferred to as the forward premium puzzleis precisely what makes
the carry trade profitable on average. Another puzzling feature of cur-
rencies is that dramatic exchange rate movements occasionally happen
without fundamental news announcements, for example, the large de-
preciation 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 fundamen-
tal 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) in-
vestment 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 investment cur-
rencies; (iii) speculators positions increase crash risk; (iv) carry trade

2009 by the National Bureau of Economic Research. All rights reserved.

9780226002040/2009/20080501$10.00
314 Brunnermeier, Nagel, and Pedersen

Fig. 1. U.S. dollar/Japanese yen exchange rate from 1996 to 2000

losses increase the price of crash risk but lower speculator positions and
the probability of a crash; (v) an increase in global risk or risk aversion
as measured by the VIX equityoption implied volatility index coin-
cides with reductions in speculator carry positions (unwind) and carry
trade losses; (vi) a higher level of VIX predicts higher returns for invest-
ment currencies and lower returns for funding currencies, and control-
ling for VIX reduces the predictive coefficient for interest rate
differentials, thus helping resolve the UIP puzzle; (vii) currencies with
similar levels of interest rate comove with each other, controlling for
other effects. (viii) More generally, the crash risk we document in this
paper may discourage speculators from taking on large enough posi-
tions to enforce UIP. Crash risk may thus help explain the empirically
welldocumented violation of the UIP.
Our findings share several features of the liquidity spirals that arise
in the model of Brunnermeier and Pedersen (2009). They show theoret-
ically that securities that speculators invest in have a positive average
return and a negative skewness. The positive return is a premium for
providing liquidity, and the negative skewness arises from an asym-
metric response to fundamental shocks: shocks that lead to speculator
losses are amplified when speculators hit funding constraints and un-
wind their positions, further depressing prices, increasing the funding
problems, volatility, and margins, and so on. Conversely, shocks that
lead to speculator gains are not amplified. Further, Brunnermeier and
Pedersen (2009) show that securities where speculators have long posi-
tions will move together, as will securities that they short.
In the currency setting, we can envision a country suddenly increas-
ing its interest rate and thereby attracting foreign capitalpossibly
worsening the current account.2 In a frictionless and riskneutral econ-
omy, this should lead to an immediate appreciation of the currency
associated with an inflow of capitaland a future depreciation of the
exchange rate such that UIP holds. In the presence of liquidity constraints,
Carry Trades and Currency Crashes 315

however, capital only arrives slowly such that the exchange rate only ap-
preciates gradually, occasionally disrupted by sudden depreciations as
speculative capital is withdrawn. Mitchell, Pedersen, and Pulvino (2007)
document the effect of slowmoving capital in other markets.
In contrast, a crash after a currency bubble, which can emerge when
each investor holds on to his carry trade position too long since he does
not know when others unwind their position, can be price correcting
(Abreu and Brunnermeier 2003). Plantin and Shin (2007) show in a dy-
namic global games framework that carry trades can be destabilizing
when strategic complementarities arise, which is the case if (i) speculators
trades occur sequentially in random order and (ii) as in Brunnermeier and
Pedersen (2009), trading requires capital and margins requirements be-
come more stringent when liquidity is tight. Our empirical findings sug-
gest an initial underreaction due to slowmoving capital subject to
liquidity risk but are also consistent with a longrun overreaction.
Our empirical study uses timeseries data on the exchange rates of
eight major currencies relative to the U.S. dollar. For each of these eight
currencies, we calculate realized skewness from daily data within
(overlapping) quarterly time periods. We show in the cross section
and in the time series that high interest rate differentials predict nega-
tive skewness, that is, carry trade returns have crash risk. Our finding is
consistent with the saying among traders that exchange rates go up by
the stairs and down by the elevator. We note that this saying must be un-
derstood conditionally: currencies do not have unconditional skewness
that is, the skewness of a randomly chosen currency pair is zerobecause
country As positive skewness is country Bs negative skewness. Hence,
our finding is that the trader saying holds for investment currencies, while
the reverse holds for funding currencies. Further, we find that high inter-
est rate differentials predict positive speculator positions, consistent with
speculators being long the carry trade on average. The top panel in figure 2
clearly shows a negative relationship between average currency skewness
and the average interest rate differential. We see that the countries line up
very closely around the downward sloping line, with an R2 of 81%. For
example, skewness is positive and highest for Japanese yen (a funding
currency), which also has the most negative interest rate differential.
At the other end of the skewness spectrum, one finds the the two major
investment currencies Australian and New Zealand dollar, which have
the secondhighest interest rate differentials.
Next, we study the risk premium associated with crash risk, that is,
the price of crash risk. In particular, we consider the socalled risk
reversal, which is the implied volatility of an outofthemoney call
Fig. 2. Crosssection of empirical skewness (top panel ) and of risk reversal (bottom panel ),
reflecting implied (riskneutral) skewness, for different quarterly interest rate differentials
i
 i.
Carry Trades and Currency Crashes 317

option minus the implied volatility of an equally outofthemoney put.

If the exchange rate is symmetrically distributed under the riskneutral
measure, then the risk reversal is zero since the implied volatilities are
the same. This means that the cost of a call can be offset by shorting the
put. On the other hand, if the riskneutral distribution of the exchange
rate is negatively (positively) skewed, the price of the risk reversal is neg-
ative (positive). Hence, the risk reversal measures the combined effects
of expected skewness and a skewness risk premium. Said differently, it
measures the cost of buying protection on a currency position to limit the
possible gains and losses.
In the cross section, the average implied skewness from risk reversals
is also negatively related to the average rate differential (bottom panel
of fig. 2), suggesting a close crosssectional relationship between our
physical skewness measure and the riskneutral implied skewness.
The timeseries relationship between actual skewness and price of a risk
reversal contract is more surprising: a higher risk reversal predicts a
lower future skewness, controlling for the interest rate differential. This
finding is related to our finding that carry trade losses lead to lower
speculator positions, a higher risk reversal, and a lower future skew-
ness, though we must acknowledge the possible peso problem in esti-
mation.3 Hence, after a crash, speculators are willing to pay more for
insurance, the price of insurance increases, and the future crash risk
goes down, perhaps because of the smaller speculator positions. This
has parallels to the market for catastrophe insurance as documented
by Froot and OConnell (1999) and Froot (2001).
Funding constraints are likely to be particularly important during fi-
nancial dislocations when global risk or risk aversion increases, leading
to possible redemptions of capital by speculators, losses, increased vol-
atility, and increased margins. To measure this, we consider the implied
volatility of the S&P 500, called the VIX. Note that the VIX, which is
traded at the Chicago Board Options Exchange (CBOE), is not mechani-
cally linked to exchange rates since it is derived from equity options.
We show that during weeks in which the VIX increases, the carry trade
tends to incur losses. We also find that riskreversal prices and carry
trade activity (both contemporaneous and predicted future activity) de-
cline during these times. The decrease in the price of risk reversals
could be due to an increase in the price of insurance against a crash risk,
or it could simply reflect an objective increase in the probability of a
crash. As another proxy for funding liquidity, we also examine the ef-
fect of the TED spread, the difference between the London Interbank
318 Brunnermeier, Nagel, and Pedersen

Offered Rate (LIBOR) interbank market interest rate and the riskfree
TBill rate. An increase in the TED spread has effects similar to an in-
crease in the VIX although with less statistical power.
Further, we find that high levels of the TED and the VIX predict
higher future returns to the carry trade, that is, relatively higher returns
for high interest currencies and low returns to low interest currencies.
Importantly, controlling for this effect reduces the predictability of inter-
est rates, that is, this helps to explain the UIP violation. Overall, these
findings are consistent with a model in which higher implied volatility
or TED spread leads to tighter funding liquidity, forcing a reduction in
carry trade positions, thus making the underreaction stronger and re-
turns higher going forward.
Finally, we document that currencies with similar interest rate comove,
controlling for certain fundamentals and countrypair fixed effects. This
could be due to common changes in the size of the carry trade that lead to
common movements in investment currencies, and common opposite
movements in funding currencies.
The structure of the paper is the following. Section II provides a brief
summary of related papers. Section III describes the data sources and
provides summary statistics. Our main results are presented in Section IV.
Section V concludes.

II. Related Literature

There is an extensive literature in macroeconomics and finance on the

forward premium puzzle, which focuses implicitly on the mean return
of the carry trade. Froot and Thaler (1990), Lewis (1995), and Engel
(1996) are nice survey articles. The forward premium puzzle is also re-
lated to Meese and Rogoffs (1983) finding that exchange rates follow a
near random walk allowing investors to take advantage of the inter-
est differential without suffering an exchange rate depreciation. It is
only a near random walk since highinterestbearing currencies even
tend to appreciate (albeit with a low forecast R2 ) and in the long run
exchange rates tend to converge to their purchasing power parity
levels.
More recently, Bacchetta and van Wincoop (2007) attribute the failure
of UIP to infrequent revisions of investor portfolio decisions. Lustig
and Verdelhan (2007) focus on the crosssectional variation between
the returns of high and low interest rate currencies and make the case that
the returns on currencies with high interest rates have higher loading on
Carry Trades and Currency Crashes 319

consumption growth risk. Burnside (2007) argues, however, that their

model leaves unexplained a highly significant excess zerobeta rate
(i.e., intercept term), and Burnside et al. (2006) find that the return
of the carry trade portfolio is uncorrelated to standard risk factors, at-
tributing instead the forward premium to market frictions (bidask
spreads, price pressure, and timevarying adverse selection in Burnside,
Eichenbaum, and Rebelo [2007]). Jylh, Lyytinen, and Suominen (2008)
argue that inflation risk is higher in high interest rate currencies and
show a positive relationship between carry trade returns and hedge
fund indices.
Our analysis is among the first to examine empirically the skewness
of exchange rate movements conditional on the interest rate differential,
that is, on the crash risk of carry trade strategies. Farhi and Gabaix (2008)
develop a model in which the forward premium arises because certain
countries are more exposed to rare global fundamental disaster events.
Their model is calibrated to also match skewness patterns obtained from
FX (foreign exchange) option prices. Instead of focusing on exogenous ex-
treme productivity shocks, we provide evidence consistent with a theory
that currency crashes are often the result of endogenous unwinding of
carry trade activity caused by liquidity spirals. Bhansali (2007) argues that
carry trades are essentially short volatility and documents that option
based carry trades yield excess returns. Jurek (2007) finds that the return
to the carry over the period 19992007 with downside protection from put
options of various moneyness is positive. Further, he finds that the more
protection one buys on the carry trade, the smaller is the average return
and Sharpe ratio. Ranaldo and Sderlind's (2007) finding that safehaven
currencies appreciate when stock market volatility increases can be re-
lated to our third set of findings that unwinding of carry trades is corre-
lated with the volatility index, VIX.
Gagnon and Chaboud (2007) focus primarily on the U.S. dollar to Jap-
anese yen exchange rate and link the crashes to balance sheet data of the
official sector, the Japanese banking sector and households. Galati,
Heath, and McGuire (2007) point to additional data sources and net
bank flows between countries that are useful for capturing carry trade
activity. Klitgaard and Weir (2004) make use of weekly net position data
on futures traded on the CMEas we doand document a contempo-
raneous (but not predictive) relationship between weekly changes in
speculators net positions and exchange rate moves. Finally, there are
numerous papers that study crash risk and skewness in the stock mar-
ket. Chen, Hong, and Stein (2001) seems to be closest to our study.4
320 Brunnermeier, Nagel, and Pedersen

III. Data and Definitions

We collect daily nominal exchange rates to the U.S. dollar (USD) and
3month interbank interest rates from Datastream from 1986 to 2006
for eight major developed markets: Australia (AUD), Canada (CAD),
Japan (JPY), New Zealand (NZD), Norway (NOK), Switzerland (CHF),
Great Britain (GBP), and the euro area (EUR), as well as the eurodollar
LIBOR. For the period before the introduction of the euro on January 1,
1999, we splice the euro series together with the exchange rate of the Ger-
man mark to the U.S. dollar, and we use German 3month interbank rates
in place of euro interbank rates. For most tests below we use a quarterly
horizon to measure exchange rate changes, and hence 3 months is the
appropriate horizon for interest rates to apply uncovered interest parity
in straightforward fashion.
We denote the logarithm of the nominal exchange rate (units of for-
eign currency per dollar) by
st log nominal exchange rate:
The logarithm of the domestic U.S. interest rate at time t is denoted by it
and the log foreign interest rate by i
t . We denote the return of an invest-
ment in the foreign currency investment financed by borrowing in the
domestic currency by
zt1 i
t  it  st1 ;
where st1 st1  st is the depreciation of the foreign currency. It is a
measure of exchange rate return in excess of the prediction by uncovered
interest parity since under UIP, zt should not be forecastable:
Et zt1  0: UIP
Hence, one can think of z as the abnormal return to a carry trade strategy
where the foreign currency is the investment currency and the dollar is
the funding currency. In most of our analysis, and in line with most of
the literature on UIP, we look at interest rate differentials and currency
excess returns expressed relative to the USD. Carry traders, however, do
not necessarily take positions relative to the USD. For example, to exploit
the high interest rates in AUD and the low interest rates in JPY in recent
years, carry traders may have taken a long position in AUD, financed by
borrowing in JPY (or the synthetic equivalent of this position with futures
or OTC currency forwards). Our analysis nevertheless sheds light on the
profitability of such a strategy. The AUD in recent years offered higher in-
terest rates than USD, so our regressions predict an appreciation of the
Carry Trades and Currency Crashes 321

AUD relative to the USD. The JPY in recent years offered lower interest
rates than USD, and hence our regressions predict a depreciation of the
JPY relative to the USD. Taken together, then, our regressions predict a de-
preciation of the JPY relative to the AUD. Thus, while we do not directly
form the carry trade strategies that investors might engage in, our regres-
sions are nevertheless informative about the conditional expected payoffs
of these strategies.
Much of our analysis focuses on the skewness of exchange rate move-
ments. To that end, we measure the skewness of daily exchange rate
changes (s) within each quarter t, denoted Skewnesst.
As a proxy for carry trade activity, we use the futures position data
from the Commodity Futures Trading Commission (CFTC). Our vari-
able Futurest is the net (long minus short) futures position of noncom-
mercial traders in the foreign currency, expressed as a fraction of total
open interest of all traders. Noncommercial traders are those that are
classified as using futures not for hedging purposes by the CFTC. This
basically means that they are investors that use futures for speculative
purposes. We have data from 1986 for five countries (CAD, JPY, CHF,
GBP, EUR), and, in our quarterly analysis, we use the last available
CFTC positions report in each quarter. A positive futures position is
economically equivalent to a currency trade in which the foreign cur-
rency is the investment currency and the dollar is the funding currency,
and, indeed, few speculators implement the carry trade by actually bor-
rowing and trading in the spot currency market. We note, however, that
the position data are not perfect because of the imperfect classification of
commercial and noncommercial traders and, more importantly, because
much of the liquidity in the currency market is in the overthecounter
forward market. Nevertheless, our data are the best publicly available
data, and they give a sense of the direction of trade for speculators.
We use data on foreign exchange options to measure the cost of insur-
ing against crash risk or, said differently, the riskneutral skewness. Spe-
cifically, we obtain data from JPMorgan Chase on quotes of 25 1month
risk reversals.5 A risk reversal is the difference between the implied vola-
tility of an outofthemoney FX call option and the implied volatility of
an outofthemoney FX put option. This is a measure of the cost of a long
position in a call combined with a short position in a put, that is, the cost
of buying insurance against foreign currency appreciation, financed by
providing insurance against foreign currency depreciation.6 If the un-
derlying distribution of exchange rate movements is symmetric, the
price of the call exactly offsets the price of the put, and the value of the
risk reversal is zero. Hence, if the price of the risk reversal differs from
322 Brunnermeier, Nagel, and Pedersen

zero, investors believe that foreign exchange movements are positively

or negatively skewed (in riskneutral terms). In other words, with con-
stant risk premia, a more positive skewness would lead to a higher value
of this risk reversal, and a more negative skewness would lead to a more
negative value of the risk reversal. Of course, due to risk premia the risk
neutral skewness is not necessarily equal to the physical skewness of ex-
change rate changes. Figures A1, A2, and A3 in the appendix depict the
time series of exchange rates, interest rate differentials, skewness, and
futures positions for the various currencies.

IV. Results

A. Summary Statistics and Simple CrossSectional Evidence

A currencybycurrency perspective. We begin by highlighting some basic

features of each currency separately in our summary statistics in table 1.
Table 1 shows that there is a positive crosssectional correlation be-
tween the average interest rate differential i
t1  it1 and the average
excess return zt , which points to the violations of UIP in the data. For
example, the currency with the most negative average excess return
(JPY) of 0.004 also had the most negative average interest rate differen-
tial relative to the U.S. dollar of 0.007. The currency with the highest
excess return (NZD) of 0.013 also had the highest average interest rate
differential of 0.009.
It is also apparent from table 1 and from figure 2 that there is a clear
negative crosssectional correlation between skewness and the average

Table 1
Summary Statistics (Means)
AUD CAD JPY NZD NOK CHF GBP EUR
st .003 .002 .003 .005 .002 .004 .004 .004
zt .009 .004 .004 .013 .007 .001 .009 .003
i
t1  it1 .006 .002 .007 .009 .005 .004 .005 .001
Futures positions .059 .097 .067 .052 .031
Skewness .322 .143 .318 .297 .019 .144 .094 .131
Risk reversals .426 .099 1.059 .467 .350 .409 .009 .329
Note: Quarterly data, 19862006 (19982006 for risk reversals). st is the quarterly change
in the foreign exchange rate (units of foreign currency per U.S. dollar), zt is the return
from investing in a long position in the foreign currency financed by borrowing in the
domestic currency. Futures positions refers to the net long position in foreign currency
futures of noncommercial traders. Risk reversals are the implied volatility difference be-
tween 1month foreign currency call and put options, as described in the text.
Carry Trades and Currency Crashes 323

interest rate differential. This negative correlation between interest rate

differentials and skewness shows that carry trades are exposed to nega-
tive skewness. An investor taking a carry trade investing in AUD financed
by borrowing in USD during our sample period would have earned both
the average interest rate differential of 0.006 plus the excess FX return on
AUD relative to USD of 0.003 but would have been subject to the negative
skewness of 0.322, on average, of the daily return on the carry trade. An
investor engaging in carry trades borrowing in JPY and investing in USD
would have earned the interest rate differential of 0.007 minus the loss
from the excess return of JPY relative to USD of 0.003, but would have
been subject to negative skewness of 0.318.
The summary statistics also show that speculators are on average carry
traders since there is a clear positive correlation between the average in-
terest rate differential and the average net futures position of speculators
in the respective currency. For example, speculators have large short posi-
tions in JPY, which has the most negative average interest rate differential.
Finally, the last row of table 1 shows the average value of risk rever-
sals, for the subset of our sample from 1998 to 2006 for which we have
riskreversal data. Recall that the risk reversals provide a measure of
the riskneutral skewness in currency changes. The table and figure 2,
bottom panel, show that countries with low interest rates tend to have
positive riskneutral skewness, while countries with high interest rates
tend to have negative riskneutral skewness.
A portfolio perspective. We also consider the crosssectional relation-
ship between carry and returns by looking at the performance of
longshort portfolios where we vary the number of currencies included
in the portfolio as reported in table 2. Specifically, our carry portfolio
has long positions in the k currencies with the highest interest rates

Table 2
Summary Statistics for Carry Trade Portfolio Returns
1 Long, 1 Short 2 Long, 2 Short 3 Long, 3 Short
Weekly Quarterly Weekly Quarterly Weekly Quarterly
Average return .002 .022 .001 .016 .001 .018
Standard deviation .017 .068 .013 .051 .011 .045
Skewness .717 .700 .537 .748 .695 .977
Kurtosis 2.851 .674 1.534 .661 2.597 1.968
Annualized Sharpe ratio .704 .654 .592 .638 .747 .784
Note: Quarterly data, 19862006, weekly data 19922006 for an equally weighted carry
trade portfolio that is long in the k 1; 2; 3 currencies with the highest interest rates in
the beginning of each week/quarter and short in the k currencies with the lowest interest
rates.
324 Brunnermeier, Nagel, and Pedersen

in the beginning of each week (quarter) and short positions in the k cur-
rencies with the lowest interest rates, where each currency is weighted
equally and we consider k 1; 2; 3.
We see that the carry trade portfolios have large Sharpe ratios, nega-
tive skewness, and positive excess kurtosis. This means that the carry
trade is profitable on average but has crash risk and fat tails.
We find no evidence that the negative skewness or excess kurtosis get
diversified away as more currencies are added to the carry trade port-
folio, at least with the simple equalweighted portfolio strategies that
we are considering here. The fact that skewness cannot easily be diver-
sified away suggests that currency crashes are correlated across differ-
ent countries, depending on interest rate differentials. This correlation
could be driven by exposure to common (crash) risk factors, and later
we provide evidence that liquidity risk is one such driving risk factor.
To get a sense of the magnitudes, we can compare the skewness of the
carry trade portfolio returns to the skewness of the U.S. stock market
portfolio. Using the same sample periods for weekly and quarterly data
as in table 2, the Center for Research in Security Prices valueweighted
U.S. stock market index log return has skewness of 0.41 weekly and
0.88 quarterly, and annualized Sharpe ratios of 0.44 weekly and 0.41
quarterly. Hence, the skewness of the carry trade portfolio returns is
roughly comparable to the magnitude of skewness of the stock market
index. Further, consistent with our FX findings, equity skewness cannot
be diversified away. On the contrary, diversified equity indices are more
negatively skewed than individual stocks, which are positively skewed.
Hence, the UIP puzzle that the carry trade has a high average return
and our finding of its negative skewness parallels the equity premium
puzzle that the equity market has a high average return and a negative
skewness. It also parallels the puzzling high average returns to shorting
index options that come with significant negative skewness since the
stock market crash in 1987. Hence the high returns of negatively skewed
assets could be part of a general phenomenon, as argued in Brunnermeier,
Gollier, and Parker (2007).
Another way to consider the magnitude of carry trade skewness is to
ask whether it is a concern to professional traders in the FX market and,
consequently, can be a factor driving currency risk premia. We believe it
is. This is especially true since currency trades are often conducted by
highly leveraged professional investors (Gagnon and Chaboud 2007;
Galati et al. 2007). Hence, while the equity premium likely depends on
individual investors propensity to buy unlevered equity, the correction
of UIP through currency carry trades largely depends on professional
Carry Trades and Currency Crashes 325

traders willingness to lever up. When traders lever up, however, they
risk forced liquidation due to a run: investors redeeming capital or coun-
terparties refusing to finance the positions. Hence, a currency crash may
force traders to eliminate or downsize (delever) their positions such that
they fail to enjoy the subsequent rebound in the carry return. Further, as
we show later, the carry trade often has losses precisely when traders
have funding problems.
Summing up, our simple crosssectional findings and our evidence
from longshort portfolio returns point to a clear relationship between
interest rates and currency crash risk. One might wonder, however,
whether this is driven by fundamental differences across countries that
lead to differences in both their interest rate and their currency risk. To
control for countryspecific effects, our analysis to follow focuses on
timeseries evidence with country fixed effects. As we shall see, the inter-
est rateskewness link is also strong in the time series, and several new
interesting results arise. Indeed, the link between actual and riskneutral
skewness is more intricate in the time series, perhaps because of liquid-
ity crises that come and go.

B. Carry Predicts Currency Crashes

To link the interest rate differential to currency trades and crash risk, we
perform some simple predictive regressions as reported in table 3. First,
we confirm that our data are consistent with the wellknown violation
of the UIP. We see that this is the case in the first column of table 3,
which has the results of the regression of the return on a foreign cur-
rency investment financed by borrowing in USD in quarter t , on the
interest rate differential in quarter t:
zt a bi
t  it t :
We use a series of univariate pooled panel regressions with country
fixed effects, which means that we work with withincountry time var-
iation of interest rate differentials and FX excess returns. We later con-
sider a more dynamic vectorautoregressive specification. The table
reports only the slope coefficient b. The results show the familiar results
that currencies with high interest rate differentials to the USD have pre-
dictably high returns over the next quarters. This violation in UIP is
also apparent from figure A1 in the appendix, which plots the exchange
rates and interest rate differentials.
The second column in table 3 reports similar regressions, but now with
speculators futures positions as the dependent variable. The positive
326 Brunnermeier, Nagel, and Pedersen

Table 3
Future Excess FX Return z, Futures Positions, and Skewness Regressed on i
t  it
FX Return z Futures Skewness
t+1 2.17 8.26 23.92
(.78) (5.06) (3.87)
t+2 2.24 8.06 23.20
(.70) (5.08) (3.71)
t+3 1.87 5.96 23.65
(.66) (4.68) (3.87)
t+4 1.50 6.41 23.28
(.63) (4.44) (4.65)
t+5 1.11 5.87 23.49
(.52) (3.47) (5.05)
t+6 .76 4.72 22.24
(.48) (2.52) (5.00)
t+7 .68 4.27 21.23
(.49) (1.91) (4.09)
t+8 .44 2.81 16.96
(.55) (2.12) (4.03)
t+9 .27 .46 12.90
(.63) (2.41) (3.45)
t + 10 .04 .96 11.14
(.78) (3.26) (3.74)
Note: Panel regressions with country fixed effects and quarterly data, 19862006. The re-
gressions with Futurest+ as the dependent variable include CAD, JPY, CHF, GBP, and
EUR only (currencies for which we have futures positions data since 1986). Standard errors
in parentheses are robust to withintime period correlation of residuals and are adjusted
for serial correlation with a NeweyWest covariance matrix with 10 lags.

coefficient for quarter t 1 indicates that there is carry trade activity in

the futures market that tries to exploit the violations of UIP. When the
interest rate differential is high (relative to the timeseries mean for the
currency in question), futures traders tend to take more long positions
in that currency, betting on appreciation of the high interest rate currency.
In the same way as the estimated coefficients in column 1 decline toward
zero with increasing forecast horizon, the estimated coefficients for fu-
tures positions in column 2 also decline toward zero. Unlike column 1,
however, we obtain only marginally significant coefficient estimates, in-
dicating that there is quite a lot of statistical uncertainty about the time
variation of futures positions in relation to movements in the interest rate
differential. This somewhat noisy link between interest rates and specu-
lator positions is also seen in figure A3 in the appendix.
The third column looks at conditional skewness. Negative conditional
skewness can be interpreted as a measure of crash risk or downside
risk inherent in carry trade strategies. We regress our withinquarter
estimates of the skewness of daily FX rate changes in quarter t on
Carry Trades and Currency Crashes 327

the interest rate differential at the end of quarter t. We see that interest
rate differentials is a statistically highly significant negative predictor of
skewness, and the coefficients decline to zero only slowly as the forecast
horizon is extended. This implies that carry trades are exposed to crash
risk: in times when the interest rate differential is high, and therefore
carry trades look particularly attractive in terms of conditional mean re-
turn, the skewness of carry trade returns is also particularly negative.
Thus, in times of high interest rate differentials, carry trade investors
that are long currencies might go up by the stairs but occasionally
come down by the elevator. The interest rateskewness link is also evi-
dent in the timeseries plots in figure A2 in the appendix.
To illustrate the crash risk visually, we next estimate the distribution
of excess currency return zt conditional on the interest rate differential
i
t1  it1 . Figure 3 plots kernelsmoothed density estimates with obser-
vations in the sample split into three groups based on the interest rate
differential with country fixed effects. The top panel plots the distribution
of quarterly returns, with observations split into i
t1  it1 < 0:005,

Fig. 3. Kernel density estimates of distribution of foreign exchange returns depending on

interest rate differential. Interest rate differential groups after removing country fixed effects,
quarterly (top panel): < .005 (dashed line), 0.005 to 0.005 (solid line), > 0.005 (dotted line);
weekly (bottom panel): < 0.01 (dashed line), 0.01 to 0.01 (solid line), > 0.01 (dotted line).
328 Brunnermeier, Nagel, and Pedersen

0:005 i
t1  it1 0:005, and i
t1  it1 > 0:005. The bottom panel
plots the distribution of weekly returns with cutoffs for i
t1  it1 at
0.01 and 0.01 (the higher number of observations with weekly data allow
us to move the cutoffs a bit further into the tails). Focusing on the top panel,
it is apparent that when the interest rate differential is highly positive, the
distribution of FX excess returns has a higher mean but also strong nega-
tive skewness, with a long tail on the left. When the interest rate differential
is negative, we see the opposite, although somewhat more moderate, with
a long tail to the right. Interestingly, even though the mean is higher with
higher interest rate differentials, the most negative outcomes are actually
most likely to occur in this case. Similarly, extremely positive realizations
are most likely to occur when interest differentials are strongly negative.
The bottom graph with weekly data shows broadly similar patterns. Hence,
while our regressions focus on skewness measures derived from daily FX
rate changes, the negative relationship between interest rate differentials
and skewness also shows up at weekly and quarterly frequencies.
Figure 4 presents kernelsmoothed density estimates for the carry
trade portfolio returns. For this graph, we focus on the equalweighted

Fig. 4. Kernel density estimates of distribution of excess returns on a carry trade portfolio
(long three high interest currencies, short three low interest currencies): top panel shows
quarterly, while bottom panel shows weekly excess returns.
Carry Trades and Currency Crashes 329

portfolio that takes a long position every week (quarter) in the three
highest interest rate currencies and a short position in the three lowest
interest rate currencies. The figure clearly shows the fat left tail of the
distributions, in particular at the quarterly frequency.

C. Predictors of Currency Crashes Risk and the Price of Crash Risk

We have seen that interest rate differentials predict skewness. We next

look for other predictors of skewness and the price of skewness. In par-
ticular, we focus on how the level of carry trade activity and recent
losses of carry trade strategies affect physical and riskneutral condi-
tional skewness.
Table 4 presents regressions of skewness measured within quarter t 1
or risk reversals measured at the end of quarter t, on timet variables. These
regressions are again pooled panel regressions with country fixed effects.
The first column once again shows that i
t  it is a strong negative predictor
of future skewness. In addition, the regression shows that skewness is per-
sistent and that futures positions are negatively related to future skewness.
The second column further shows that the past currency return zt nega-
tively predicts skewness. This can be interpreted as currency gains leading
to larger speculator positions and larger future crash risk. We also find that
the currency gain variable drives out the futures position variable, be-
cause the futures positions at the end of quarter t are strongly positively

Table 4
Forecasting Crashes and the Price of Crash Risk
Skewnesst+1 Skewnesst+1 Skewnesst+1 RiskRevt RiskRevt
i
t  it 28.51 22.18 27.34 15.51 30.70
(11.59) (12.59) (11.52) (29.20) (25.91)
zt 3.34 2.11 7.87
(.60) (.69) (1.39)
Futurest .26 .13 .18 1.16 .27
(.12) (.15) (.14) (.19) (.12)
Skewnesst .12 .18 .17 .10 .02
(.05) (.05) (.05) (.09) (.10)
RiskRevt .16
(.04)
R2 .12 .18 .21 .20 .41
Note: Panel regressions with country fixed effects and quarterly data, 19982006, AUD,
CAD, JPY, CHF, GBP, and EUR only. Standard errors in parentheses are robust to within
time period correlation of residuals and are adjusted for serial correlation with a Newey
West covariance matrix with six lags. The reported R2 is an adjusted R2 net of the fixed
effects.
330 Brunnermeier, Nagel, and Pedersen

related to excess returns zt during that quarter (not reported in the table).
Perhaps the past return is a better measure of speculator positions given
the problems with the position data from the CFTC. Taken together, the
results imply that crash risk of currencies is particularly high following
high returns. Times when past returns are high also tend to be times when
futures positions are high. This points to the possibility that part of the
skewness of carry trade payoffs may be endogenously created by carry
trade activity. Gains on carry trades lead to further buildup of carry trade
activity, which then also increases the potential impact on FX rates of an
unwinding of those carry trades after losses and which manifests itself in
the data as negative conditional skewness.
In the third column we add risk reversals to the regression, and we
obtain a surprising result. Controlling for interest rate differentials and
the other variables in the regression, the relationship between risk re-
versals and future skewness is negative. This means that, everything
else equal, a higher price for insurance against downside risk predicts
lower future skewness. The bivariate correlation between risk reversals
and skewness (untabulated) is positive, however, and so controlling for
the other variables, in particular the interest rate differential, gives rise
to the somewhat surprising negative coefficient. This is consistent with
the interpretation that after a crash, speculators are willing to pay
more for insurance, the price of insurance increases even though
the future crash risk goes down, perhaps because of the smaller spec-
ulator positions. This parallels the market for catastrophe insurance
as documented by Froot and OConnell (1999) and Froot (2001).
The fourth and fifth columns in the table show the regression of risk
reversals on the other variables. As the table shows, risk reversals have
a negative relationship to i
t  it , just like physical/actual skewness in
the first three columns. Although for risk reversals the relationship is
not statistically significant, the point estimate suggests that risk rever-
sals and physical skewness may have a common component related to
to i
t  it . A stark difference exists, however, in their relationship to zt .
When a currency has had a high excess return in quarter t, this predicts
a smaller (more negative) future physical skewness, but a larger risk re-
versal, and thus riskneutral skewness, at the end of quarter t. This means
that there is a wedge between the physical and riskneutral skewness,
that is, a skewness risk premium, that varies negatively with recent ex-
cess returns of the currency. This again points to the possibility that skew-
ness is endogenously created by carry trade activity: when recent carry
trade returns are strongly negative, carry trades get unwound, and there
is less crash risk in the future. But, in addition to outright liquidation of
Carry Trades and Currency Crashes 331

carry trades, part of the unwinding seems to happen by carry traders buy-
ing insurance against downside risk, which drives up the price of insur-
ance against crash risk, despite the fact that there is less negative
conditional physical skewness.

D. Are Carry Trades (De)Stabilizing?

At horizons of more than one period, we focused so far on univariate

forecasts with the interest rate differential as predictor. To shed some
light on the dynamic relationships between interest rate differentials,
FX rate changes, futures positions, and skewness over longer horizons,
and to address the question whether carry traders are stabilizing or de-
stabilizing, we estimate a vector autoregression (VAR). We first estimate
a thirdorder VAR with zt , i
t  it , Skewnesst, and Futurest using quar-
terly data from 1986 to 2006 for the five currencies for which we have fu-
tures positions data. Figure 5 reports impulse response function estimated
from this VAR(3) system for shocks to the interest rate differential. The
shocks underlying the impulse responses are based on a Choleski de-
composition with the ordering i
t  it , zt , Skewnesst, and Futurest, the

Fig. 5. Impulse response functions from VAR(3) for shock to interest rate differential
with 90% confidence intervals.
332 Brunnermeier, Nagel, and Pedersen

most important assumption being that shocks to the interest rate differential
cause contemporaneous changes in the other three variables but shocks in
the other three variables do not affect the VAR innovation of the interest
rate differential. The figure also shows 90% (bootstrap) confidence in-
tervals following Kilian (1998), which account for the bias and skew-
ness in the smallsample distribution of the impulse response functions.
The bottom left graph in figure 5 shows that the forecasted futures
positions correspond closely to the forecasted interest rate differentials
in the top left graph, consistent with higher interest rate differentials
leading to more carry trade activity. The bottom right graph confirms
that conditional skewness gets more negative following a positive shock
to the interest rate differential, followed by slow reversion toward the
mean. Overall, the VAR results confirm the basic facts from the univari-
ate forecasting regressions in table 3.
The top left graph in figure 5 shows that after a positive shock to the
interest rate differential, the interest rate differential keeps rising for
about 4 quarters before it slowly reverts back to the mean. The top right
graph shows that positive shocks to the interest rate differentials also
lead to appreciation of the foreign exchange rate. If the UIP were to hold,
the exchange rate would jump initially due to the interest rate shock in
one currency and depreciate subsequently. Stated differently, the cumu-
lative excess returns on carry trades would jump initially and stay con-
stant afterward. Instead, as the figure shows, when the foreign interest
rate increases relative to the domestic interest rate, substantial excess re-
turns accumulate to a carry trader over this horizon since the foreign
currency does not depreciate enough in the next 15 quarters to offset
the persistently high interest rate differential.
VARs can also help analyze the important question of whether carry
trades are profitable because exchange rates initially underreact to inter-
est rate shocks or, alternatively, because exchange rates overreact as too
many traders pile and then later fall back toward fundamentals as carry
trades unwind their positions. The latter view would be consistent with
the popular concern that carry trade activity creates bubbles by pre-
venting investment currencies from depreciating as described by the
UIP. Each individual speculator might find it optimal to hold on to his
carry trades since he does not know when others unwind their positions.
That is, each trader faces a synchronization risk as modeled in Abreu
and Brunnermeier (2003). Consequently, a pricecorrecting crash oc-
curs with a delay only when carry trades suddenly unwind. In contrast,
the underreaction view argues that capital flows, and therefore also
exchange rates, react sluggishly to shocks in interest rate differentials
Carry Trades and Currency Crashes 333

and that carry trade activity essentially helps to speed up the adjust-
ment, as conjectured by Grossman (1995). One main reason for this slug-
gish behavior may be that carry traders demand a risk premium since
they are exposed to crash risk in the form of negative skewness of carry
trade returns as we have documented. Under this hypothesis, currency
crashes in which carry traders face losses tend to move the exchange rate
further away from fundamentals (assuming that the fundamental ex-
change rate is consistent with UIP).
These two hypotheses make different predictions about the behavior
of the impulse response of the cumulative excess returns of the VAR, as il-
lustrated in the top left panel. As noted above, UIP predicts that higher
interest rate leads to a jump up in the carry return and then a flat cu-
mulative return from then onward as the future interest rate differentials
are compensated by exchange rate depreciation. Underreaction implies
that the initial jump is small and that the positive returns continue for a
while. Finally, overreaction implies that the returns are positive for a while
and then turn negative, that is, the cumulative return should be hump
shaped. As seen in figure 5, our estimated VAR is consistent with an initial
underreaction. It is also possible that there is a longrun overreaction (or
bubble). However, we cannot make a definite statement, because longrun
predictions are difficult to test econometrically, for example, because the
conclusion can be quite sensitive to the specification of the VAR. In particu-
lar, to properly capture a hump shape in cumulative excess returns may
require many lags in the VAR. But including many lags would make esti-
mates imprecise and hence make it impossible to draw any inference
about longrun impulse responses with much statistical confidence.
Importantly, we can test the hypothesis in an alternative way, namely,
by considering how much the exchange rate moves in response to inter-
est rate shocks relative to what UIP predicts. Said differently, UIP pre-
dicts not only that the cumulative return should jump up and then be
flat, it can also be used to predict how much the exchange rate should
jump, and we can compare this to the VARestimated moves to look for
under or overreaction. To do this, we need to make additional assump-
tions, namely, that the real exchange rate is stationary.
We add inflation since it is more natural to complement the UIP with
the assumption that the PPP holds in the long run and that the real ex-
change rate is stationary (rather than assuming a stationary nominal
exchange rate). In other words, the interest rate shock will affect future in-
flation, and this will ultimately affect exchange rates. Under the assumption
that the exchange rate is stationary, the UIPpredicted magnitude of the log
exchange rate change is the sum of all future loginterest rate differentials.
334 Brunnermeier, Nagel, and Pedersen

For example, if there is a surprise increase in interest rates in Japan rela-

tive to those in the United States,
i
t  it  Et1 i
t  it  > 0;
then, under UIP,
X

zt Et i
t  it   Et1 i
t  it   Et s  Et1 s ;
0

where s is the longrun level of the nominal exchange rate. Further, we

use our assumption of a stationarity of the log real exchange rate, defined
as st  p
t pt , where p
t and pt are the foreign and domestic price levels,
respectively. This yields a total UIPpredicted initial exchange rate move of
X
zt Et i
t  it   Et1 i
t  it   Et
t1  t1 
0

Et1
t1  t1 ;

where
t  t is the inflation rate differential.

After incorporating the inflation differential, we reestimate the dynam-
ics with a more parsimonious VAR to keep the number of parameters
manageable. Specifically we leave out Futures and Skewness, since these
variables have little predictive power for the other variables in the VAR, so
their exclusion has little effect on the estimated impulse response of cumu-
lative returns. Figure 6 presents the impulse response functions estimated
from this second VAR(3) that includes inflation. The ordering of shocks is
now i
t  it,
t  t , and then zt . The dashed horizontal line in the lower left
panel is the cumulated excess return predicted by the UIP, and its initial
jump reflects the present value of the future real interest rate differentials
as predicted by the VAR. It is apparent from figure 6 that the cumulative
excess returnsand hence the exchange rateinitially underreacts. If
there were more carry trade activity immediately following the shock to
the interest rate differential, then this would tend to push up the exchange
rate toward the reaction implied by UIP. While our findings do not rule out
longterm overreactionsdue to limits on our statistical power and issues
with the specification of the VARour combined results suggest that, at
least for a time period after a shock to interest rates, carry trade activity
pushes FX rates toward fundamentals rather than away from it.

E. Liquidity Risk and Unwinding of Carry Trades

Our analysis so far raised the possibility that unwinding of carry trades
could explain some of the skewness of the returns to carry trades and
Carry Trades and Currency Crashes 335

Fig. 6. Impulse response functions from VAR(3) for shock to interest rate differential
with 90% confidence intervals.

that the negative skewness of carry trade payoffs combined with the
threat of forced unwinding could be a deterrent to engaging in large
highly levered carry trade activity that would help eliminate UIP viola-
tions. To better understand these interrelationships, we try to identify
states of the world in which speculators are likely to be forced to unwind
positions due to losses, capital redemptions, increased margin, or re-
duced risk tolerance.
Identifying such states of the world empirically is not an easy task.
Ideally, we would want a measure for speculators willingness and ability
to put capital at risk, but that could depend on many (largely unobserv-
able) factors, including tightness of margin constraints, valueatrisk lim-
its, recent returns of carry trade strategies, liquidity spillovers from other
markets, the amount of risk capital devoted to carry trade strategies, and
others. We use two measures: (i) the CBOE VIX option implied volatility
index as an observable proxy that should be correlated with at least sev-
eral of these factors and (ii) the TED spread, the difference between the
3months LIBOR eurodollar rate and the 3months TBill rate. The LIBOR
336 Brunnermeier, Nagel, and Pedersen

rate reflects uncollateralized lending in the interbank market, which is

subject to default risk, while the TBill rate is riskless since it is guaran-
teed by the U.S. government. When banks face liquidity problems the
TED spread typically increases, and the TBill yield often falls due to a
flight to liquidity or flight to quality.
Prior research has shown that the VIX index is a useful measure of
the global risk appetite not only in equity, and equityoptions markets,
but also in corporate credit markets (CollinDufresne, Goldstein, and
Martin 2001) and in other, seemingly unrelated, markets. For example,
Pan and Singleton (2008) find that the VIX is strongly related to the
variation in risk premiums in sovereign credit default swaps. Moreover,
many of the financial crises of recent years, for example, the Russian/
LTCM crisis of 1998, or the financial market turmoil in the summer of
2007, were accompanied by strong increases in the VIX.
Table 5 presents pooled panel regressions with country fixed effects.
Note that so far, we could ignore the direction of the carry trade, since
the interest rate differential, futures positions, and payoffs from ex-
change rate movements switch signs when the direction of the trade is
reversed. This is not the case with the VIX or TED spread, and hence we
interact these two variables with the sign of the interest rate differential,
signi
t  it .
The first two columns show that Futurest and Futurest+1 are both
significantly negatively related to signed VIXt, meaning that carry

Table 5
Sensitivity of Weekly Carry Trade Positions, Price of Skewness Insurance, and Carry
Trade Returns to Changes in VIX
Futurest Futurest+1 RiskRevt RiskRevt+1 zt zt+1
VIXt sign(i
t1  it1 ) 1.47 1.29 5.33 2.74 .43 .03
(.77) (.57) (2.64) (3.39) (.11) (.11)
Futurest1 .09 .10
(.01) (.01)
RiskRevt1 .16 .11
(.02) (.02)
R2 .04 .06 .08 .04 .00 .00

Note: Panel regressions with country fixed effects and weekly data, 19922006 (19982006 for
risk reversals), AUD, CAD, JPY, CHF, GBP, and EUR only (only currencies for which we have
futures positions data since 1992). VIX is the CBOE volatility index. zt is the return from in-
vesting in a long position in the foreign currency financed by borrowing in the domestic cur-
rency. Standard errors in parentheses are robust to withintime period correlation of residuals
and are adjusted for serial correlation with a NeweyWest covariance matrix with
12 lags for futures, 6 for risk reversals, and 4 for returns. The reported R2 is an adjusted R2
net of the fixed effects.
Carry Trades and Currency Crashes 337

trades are unwound in times when the VIX increases. At the same
time, as shown in columns 3 and 4, risk reversals are also negatively
related to signed VIXt. The price of insurance of carry trades against
crash risk therefore increases in times of rising VIX. Finally, column 5
shows that carry trades loses money on average in times of rising
VIX.
Taken together, unwinding of carry trades in response to decreases in
global risk appetite can jointly explain the results in table 5: when trad-
ers risk tolerance declines, carry trades are unwound, which leads to a
reduction in the futures positions in investment currencies, an increase in
the price of insurance against crash risk, and bad payoffs of carry trades.
The dependence of carry trade payoffs on changes in the VIX, which ac-
cording to prior research is driven to a large extent by variations in risk
appetite, also suggests that part of the movement in investment and
funding currencies is driven by changing risk tolerance of traders and
that crashes may occur endogenously as part of the trading process with
leveraged and imperfectly capitalized traders.
We replicate the same exercise with our second measure of funding li-
quidity risk, the TED spread (table 6). It is reassuring that the coefficient
on the signed TED spread coincides with the sign of the coefficient on the
signed VIX in table 5. However, the coefficients are not statistically sig-
nificant. We do find a significant negative relationship for predicting the

Table 6
Sensitivity of Weekly Carry Trade Positions, Price of Skewness Insurance, and Carry
Trade Returns to Changes in the LIBORTBill (TED) Spread
Futurest Futurest+1 RiskRevt RiskRevt+1 zt zt+1

TEDt sign(i
t1  it1 ) .48 1.92 .71 25.05 .27 .57

(2.27) (1.85) (10.02) (13.89) (.35) (.31)
Futurest1 .09 .10
(.01) (.01)
RiskRevt1 .16 .11
(.02) (.02)
R2 .04 .06 .08 .04 .00 .00
Note: Panel regressions with country fixed effects and weekly data, 19922006 (19982006
for risk reversals), AUD, CAD, JPY, CHF, GBP, and EUR only (only currencies for which we
have futures positions data since 1992). TED is the 3month USD LIBOR minus the 3month
TBill yield. zt is the return from investing in a long position in the foreign currency financed
by borrowing in the domestic currency. Standard errors in parentheses are robust to within
time period correlation of residuals and are adjusted for serial correlation with a Newey
West covariance matrix with 12 lags for futures, 6 for risk reversals, and 4 for returns. The
reported R2 is an adjusted R2 net of the fixed effects.
338 Brunnermeier, Nagel, and Pedersen

change of next weeks risk reversal, RiskRevt+1 and, marginally so, for
next weeks excess return, zt1 . Thus, while an increase in equityoption
based VIX in table 5 is associated with a contemporaneous statistically
significant reaction of risk reversals and carry trade excess returns, a
change in the TED spread is only related to risk reversals and carry trade
returns with a week delay.
Another way of viewing these findings is that the VIX and TED are
common risk factors for exchange rates signed by their interest rate dif-
ferentials. This helps explain why a diversified carry portfolio continues
to have crash risk (negative skewness) and fat tails (excess kurtosis) as
we showed in table 2. Indeed, many of the legs to the carry trade can lose
money at the same time since the carry trades are exposed to a system-
atic crash risk that is related to flight to liquidity or a flight to quality.
Therefore, we would also expect that the return of the diversified carry
trade has negative loadings on VIXt and TEDt. Table 7 presents those
loadings for the threelong, threeshort carry trade portfolio described
earlier, and, indeed, the relationships are similar to those in the panel re-
gressions: VIXt has a strong contemporaneous correlation, but not much
effect in the following week, while TEDt has a stronger predictive rela-
tionship to the return in the following week and a smaller contempora-
neous effect.

F. Liquidity Risk Helps Explain Deviations from UIP

Given the strong contemporaneous impact of VIX on excess returns of

carry trades, it is natural to ask whether the signed VIX and possibly the

Table 7
Sensitivity of Weekly Carry Trade Portfolio Excess Returns to Changes in the VIX
and the LIBORTBill (TED) Spread
Returnt Returnt+1 Returnt Returnt+1

VIXt .94 .07

(.25) (.23)
TEDt 1.21 1.57
(.84) (.56)
R2 .05 .00 .01 .02
Note: Regressions with weekly data for the three long, three short carry trade portfolio,
19922006. TED is the 3month USD LIBOR minus the 3month TBill yield. Standard
errors in parentheses are adjusted for serial correlation with a NeweyWest covariance
matrix with four lags. The reported R2 is an adjusted R2.
Carry Trades and Currency Crashes 339

signed TED spread might help to forecast future excess returns on carry
trades in various quarters in the future. To the extent that contemporaneous
reaction of carry trade returns reflect a change in risk premiums, one
would expect that they should help forecast carry trade returns (assum-
ing sufficient statistical power). To answer this question, we replicate
our earlier forecasting regressions shown in table 3 but also include
the signed VIX (or signed TED spread) as predictor. Table 8 shows
two interesting facts: First, the coefficients of the interest rate differen-
tial in the forecasting regressions with VIX are about half of that in table 3
and less statistically significant. Second, the signed VIX is a statisti-
cally significant predictor for several quarters in the future, albeit not
for the immediate next quarter. Put together with the results of table 5
(col. 5), this suggests that an increase in VIX contemporaneously re-
duces returns on carry trades but leads to higher returns some quarters
out. The forecasting regressions with the TED spread show a similar

Table 8
Future Excess FX Return z Regressed on i
t  it and Its Interaction with VIX or TED
Forecast with VIX Forecast with TED
Excess Return at i
t  it VIXt sign(i
t1  it1 ) i
t  it TEDt sign(i
t1  it1 )
t+1 1.35 .29 2.58 .62
(1.36) (.26) (1.01) (.45)
t+2 1.37 .35 2.27 .04
(1.17) (.18) (.91) (.50)
t+3 .75 .53 1.40 .72
(1.20) (.23) (.90) (.58)
t+4 .63 .53 .96 .84
(1.22) (.23) (.90) (.59)
t+5 .93 .31 1.04 .11
(.82) (.16) (.58) (.29)
t+6 .63 .29 .18 .88
(.65) (.11) (.48) (.30)
t+7 .23 .34 .23 .70
(.90) (.16) (.57) (.28)
t+8 .05 .31 .46 .03
(.83) (.17) (.64) (.40)
t+9 .28 .0954 .41 .21
(.79) (.18) (.68) (.34)
t + 10 .30 .02 .25 .33
(.87) (.17) (.77) (.40)
Note: Panel regressions with country fixed effects and quarterly data, 19902006 for the
regressions with VIX, 19862006 for the regressions with TED. Standard errors in paren-
theses are robust to withintime period correlation of residuals and are adjusted for serial
correlation with a NeweyWest covariance matrix with 10 lags.
340 Brunnermeier, Nagel, and Pedersen

pattern, although the TED spread is only significant for lags of 6 or

7 quarters out.

G. Predictable Comovement of FX Rates

If part of the movements in investment and funding currencies are

driven by changing risk tolerance of traders, then this should also
affect the comovement of FX rates. For example, if carry traders un-
wind in response to declining risk tolerance, and their unwinding
has price impact, then this should cause funding currencies to co-
move positively with funding currencies and investment currencies
with investment currencies. Thus, everything else equal, currencies with
similar interest rates should comove closely, while currencies with
very different interest rates should have little, or even negative,
comovement.
To test this, we calculate the pairwise correlation of daily FX rate
changes within nonoverlapping 13week periods, and we regress these
correlations on ji
1  i
2 j, the absolute interest rate differential between
the countries in each pair at the start of the 13week period. The results
are shown in table 9.

Table 9
Correlation of FX Rate Changes and Magnitude of Interest Rate Differentials
(1) (2) (3) (4)
ji
1  i
2 j 10.89 6.62 16.39 13.41
(3.81) (3.62) (4.05) (6.41)
i
1 ; i
2 .63 .28 .70 .32
(.16) (.08) (.17) (.08)
Average s1 ; s2 2.54 2.56
(.08) (.08)
Time fixed effects Yes Yes
Countrypair fixed effects Yes
.18 .36 .05 .03
Note: Panel regressions, 19922006. The dependent variable is the pairwise correlation of
daily FX rate changes, estimated within nonoverlapping 13week periods. ji1  i2 j is the
absolute pairwise interest rate differential at the start of the 13week period. i1 ; i2 is the
correlation of 5day interest rate changes, estimated with overlapping windows, within
each 13week period. Average s1 ; s2 is the crosssectional average of all pairwise
correlations of daily FX rate changes within each nonoverlapping 13week period. The
reported R2 is an adjusted R2 net of the fixed effects.
Carry Trades and Currency Crashes 341

Of course, some countries might have similar interest rates and

highly correlated FX rates for reasons other than the effects of carry
trades. We control for these other reasons in several ways. First, we in-
clude i
1 ; i
2 as a control variable, the correlation of 5day interest rate
changes, estimated with overlapping windows, within each 13week
period. This variable proxies for correlated monetary policy. Second,
we also run a specification where we include countrypair fixed effects.
This should take care of other unobserved timeconstant reasons for a
country pair to have high or low correlation of FX rates. For example,
CAD and AUD FX rates have a high correlation, due to the common ex-
posure of their economies to mining, but this common exposure is largely
absorbed by the fixed effect. Finally, to make sure that the results are not
driven by the exposure of all exchange rates to a common factor, and time
variation in the volatility of this common factor, which could lead to com-
mon variation in all pairwise correlations, we include either time dum-
mies or the crosssectional average of all pairwise correlations of daily FX
rate changes within each nonoverlapping 13week period, denoted by
Average s1 ; s2 .
The estimates in table 9 show that there is a strong negative relation-
ship between ji
1  i
2 j and the FX rate correlation. A reduction of 1% in
the interest rate differential is associated with an increase of the FX rate
correlation of more than 0.1. The results are fairly similar for all speci-
fications shown in the table. In particular, the specification with country
fixed effects shows that this relationship holds even if we only consider
withincountrypair variation. In other words, when the interest rate
differential for a given country pair is lower than it is on average for
this country pair, then the correlation of the FX rate is higher than it is
on average for this country pair. This feature of the data is also consistent
with the view we suggested above, that is, that the buildup and unwind-
ing of carry trades associated with changes in traders risk tolerance has
an effect on FX rates.

V. Conclusion

This paper provides evidence of a strong link between currency car-

ry and currency crash risk: investing in high interest rate currencies
while borrowing in low interest rate currencies delivers negatively
skewed returns. We document that speculators invest in highcarry
currencies and argue that currency crashes are linked to the sudden
342 Brunnermeier, Nagel, and Pedersen

unwinding of these carry trades. Consistent with models in which

the erosion of capital increases insurance premia, we find that the
price of protecting against a crash in the aftermath of one increases
despite the fact that a subsequent crash is less likely. Further, we
document that currency crashes are positively correlated with in-
creases in implied stock market volatility VIX and the TED spread,
indicators of funding illiquidity, among other things. This could be
the outcome of a setting in which higher volatility leads to lower
available speculator capital due to higher margins and capital re-
quirements, inducing traders to cut back on their carry trade activ-
ities. Moreover, we find that a higher VIX predicts higher carry
returns going forward and that controlling for this effect reduces
the FX return predictability of interest rates, that is, it helps re-
solve the UIP violation. Finally, our finding that currencies with
similar interest rates comove with each other, controlling for other
effects, further suggests that carry trades affects exchange rate
movements.
Overall, our results are consistent with the view that macroeco-
nomic fundamentals determine which currencies have high and low
interest rates and the longrun currency levels, while illiquidity and
capital immobility lead to shortrun currency underreaction to
changes in fundamentals and occasional currency crashes due to li-
quidity crises. Hence, our findings call for new macroeconomic mod-
els in which risk premia are affected by market liquidity and funding
liquidity issues, not just shocks to productivity, output, or the utility
function.
Appendix

Time Series for Different Currencies

Fig. A1. Log interest rate differentials (solid line, left axis) and log FX rate (dashed line,
right axis).
Fig. A2. Lagged log interest rate differentials (solid line, left axis) and quarterly skewness
of daily log FX rate change (dashed line, right axis).
Carry Trades and Currency Crashes 345

Fig. A3. Log interest rate differentials (solid line, left axis) and futures positions of non-
commercial traders (dashed line, right axis).

Endnotes

Special thanks goes to Craig Burnside, Gabriele Galati, Jean Imbs, Jakub Jurek, Hanno Lustig,
Igor Makarov, Michael Melvin, Martin Oehmke, Nikolai Roussanov, Adrien Verdelhan, and
the editors Daron Acemoglu, Ken Rogoff, and Mike Woodford. We are also grateful to com-
ments from seminar participants at New York University, BGI, International Monetary
Fund, and conference participants at the German Economists Abroad conference, the
American Economics Association meeting 2008, NBER Behavioral Finance meetings, and
P. Woolley Center at the London School of Economics. Brunnermeier acknowledges finan-
cial support from the Alfred P. Sloan Foundation.
1. While the Long Term Capital Management (LTCM) debacle, which occurred be-
tween the end of August and early September 1998, is not completely unrelated, it is quite
distinct from the U.S. dollar/Japanese yen crash on October 7 and 8, 1998. Note also that
the Feds surprise interest rate cut of 0.5% happened only on October 15.
2. If the interest rate increase is due an increase in total factor productivity the additional
inflow of capital is efficient. However, if the countrys central bank increases the interest rate
to slow domestic demand in order to curb inflationary pressures, additional capital inflow
is counterproductive. In this case the central bank faces a dilemmaknown in International
Monetary Fund circles as the Tosovsk Dilemma, named for Joseph Tosovsk, former
Central Bank governor of the Czech Republic, whose attempts to dampen domestic de-
mand with higher interest rates were largely undone by larger capital inflows.
3. It should also be noted that the optionimplied skewness derived from risk reversals is
immune to peso problems, while the realized skewness measure is not.
4. See also Barberis and Huang (2007) and Brunnermeier, Gollier, and Parker (2007), in
which belief distortions create a preference for positive skewness, resulting in higher ex-
pected returns for assets and trading strategies with negatively skewed payoffs.
5. Taking the derivative of the option price with respect to the spot exchange rate gives
the option delta. An atthemoney call with exercise price at the current forward exchange
346 Brunnermeier, Nagel, and Pedersen

rate has a call delta of about a half, that is, the option price reaction is only half of the change
in the underlying exchange rate. The label 25 refers to how far out of the money the op-
tions are, namely, the strike of the call is at a call delta of 0.25, and the strike of the put is at a
call delta of 0.75.
6. Both options that form the risk reversal can be priced using the Garman and Kohlhagen
(1983) formula, which is a modified BlackScholes formula taking into account that both cur-
rencies pay a continuous yield given by their respective interest rates. Inputting the implied
volatility and other parameters into the Garman and Kohlhagen (1983) formula gives the op-
tion price in dollar terms, but the options are quoted in terms of implied volatility.

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