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Carry Trades and Tail Risk of Exchange Rates

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Carry Trades and Tail Risk of Exchange Rates,” by Chanaka N. Ganepola, critically investigates the risk associated with carry trades and the extent to which carry trade returns elucidate tail risk.

The study initially estimates the tail index for twenty-five currencies and formulates a unique inverse function for each currency, aiming to estimate the respective Value-at-Risk. The research further explores the impact of carry trade returns on the overall tail risk within the context of foreign exchange and interest rate gain, evaluating long and short positions of the trade.

The findings reveal that tail risk is primarily influenced by the long position of the carry trade and that the return of the foreign exchange component offers a better explanation of tail risk compared to the interest rate return.

Additionally, the Value-at-Risk analysis suggests that the overall strategy’s tail risk is influenced by the tail risk of the foreign exchange component embedded in the long position of the trade, shedding valuable insights on the complex dynamics of tail risk in the domain of carry trades.

Abstract Of Paper

Historically, Carry trades have been a success story for most investor and a major source of funds for emerging economies maintaining higher interest rates. Therefore it’s a timely topic to investigate the risk embedded in such transactions and to what extent the carry trade returns explain the tail risk. Initially, this research estimates the tail index of all the currencies and formulates a unique inverse function for all the currencies in relation to Power laws, with the idea of estimating the respective Value-at-Risk. This research considers twenty five currencies and replicates them in to five portfolios based on the annualised daily return of a weekly forward contract. Trade was executed assuming a U.S. investor, who goes long in a high return portfolio and short in a low return portfolio. Further, this research examines the impact of carry trade returns on the overall tail risk within the context of foreign exchange and interest rate gain in long and short positions of the trade. The results indicate that tail risk cannot be explained effectively by its returns because of its exponential nature. However, I find that tail risk is mostly influenced by the long position of the carry trade. Furthermore, the return of the foreign exchange component appears to have a better explanation on the tail risk compared to the interest rate return. The Value-at-Risk analysis also suggests that the tail risk of overall strategy is influenced by the tail risk of foreign exchange component embedded in the long position of the trade.

Original paper – Download PDF

Here you can download the PDF and original paper of Carry Trades and Tail Risk of Exchange Rates.

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Author

Chanaka N. Ganepola
Central Bank of Sri Lanka; The University of Manchester – Manchester Business School

Conclusion

The insights gleaned from the research paper significantly contribute to our understanding of the risk associated with carry trades and their impact on tail risk of exchange rates. The findings underscore the influential role of the long position of the carry trade in shaping tail risk and highlight the superior explanatory power of the return of the foreign exchange component in elucidating tail risk compared to the interest rate return.

The estimation of the tail index for different currencies and the formulation of a unique inverse function provides valuable insights into the respective Value-at-Risk, offering a nuanced understanding of the risk embedded in carry trade transactions.

These findings offer implications for investors and policymakers, prompting a reevaluation of risk management practices and investments strategies within the domain of carry trades, given their intricate relationship with tail risk and exchange rate dynamics.

Related Reading:

Carry Trades, Order Flow and the Forward Bias Puzzle

Price Overreactions in the Forex and Trading Strategies

FAQ

Q1: What is the main focus of the research paper “Carry Trades and Tail Risk of Exchange Rates” by Chanaka N. Ganepola?

A1: The main focus of the research paper is to investigate the risk associated with carry trades and to what extent carry trade returns explain the tail risk of exchange rates. The study estimates the tail index for twenty-five currencies, formulates unique inverse functions, and explores the impact of carry trade returns on overall tail risk, considering both foreign exchange and interest rate gain.

Q2: How does the research estimate the Value-at-Risk (VaR) for different currencies in the context of carry trades?

A2: The research estimates the tail index for all the currencies and formulates a unique inverse function for each currency in relation to Power laws. This is done with the aim of estimating the respective Value-at-Risk (VaR) for different currencies, providing insights into the risk embedded in carry trade transactions.

Q3: What does the research reveal about the influence of carry trade returns on tail risk and the components (foreign exchange and interest rate gain) in long and short positions of the trade?

A3: The findings indicate that tail risk is mostly influenced by the long position of the carry trade. Furthermore, the return of the foreign exchange component offers a better explanation of tail risk compared to the interest rate return. The Value-at-Risk (VaR) analysis suggests that the tail risk of the overall strategy is influenced by the tail risk of the foreign exchange component embedded in the long position of the trade.

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