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Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia

Last Updated on 10 February, 2024 by Rejaul Karim

Presented in “Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia” by Huichou Huang and Ronald MacDonald is a comprehensive framework that dissects the intricacies of currency carry trade portfolios and their associated risks.

By deriving a position-unwinding risk measure from the currency option pricing model, the study unveils a linkage between interest rate differentials, currency volatility, and global currency skewness risk. Intriguingly, the research demonstrates that high-interest-rate currencies exhibit heightened exposure to position-unwinding risk compared to their low-interest-rate counterparts.

Moreover, the paper delves into the decomposition of carry trade payoffs, emphasizing the roles of sovereign credit premium, interest rate differentials, and expected exchange rate depreciation in currency risk premia analysis.

This comprehensive analysis culminates in the revelation that sovereign credit premia and market risk sentiment encapsulate a significant portion of cross-sectional variations in carry trade excess returns, shedding new light on the intricate interplay of global liquidity imbalances, reversal, and sovereign default risk in shaping currency market dynamics.

Abstract Of Paper

In this paper we derive the measure of position-unwinding risk of currency carry trade portfolios from the currency option pricing model. The position-unwinding likelihood indicator is in nature driven by interest rate differential and currency volatility, and highly correlated with global currency skewness risk. We show that high interest-rate currencies are exposed to higher position-unwinding risk than low interest-rate currencies. We then provide a framework that decomposes carry trade payoffs into sovereign credit premium, interest rate differential, and expected exchange rate depreciation (overshooting) upon default components to analyze currency risk premia. We investigate the sovereign CDS spreads as the proxy for solvency of a state 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 (country-specific) fundamental risk that drives market volatility (global contagion channel), together with position-unwinding likelihood indicator as the market risk sentiment, captures over 90% of cross-sectional variations of carry trade excess returns. In this context, the forward premium puzzle can be understood as a composite story of sovereign credit premia, global liquidity imbalances and reversal. We further reveal that sovereign default risk also explains large proportions of the cross sections of currency momentum (over 65%) and volatility risk premium (over 80%) portfolios.

Original paper – Download PDF

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Author

Huichou Huang
City University of Hong Kong

Ronald MacDonald
University of Glasgow – Adam Smith Business School

Conclusion

In conclusion, “Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia” by Huichou Huang and Ronald MacDonald offers a groundbreaking analysis of the intricate dynamics underlying currency carry trade portfolios and their associated risks.

The derivation of the position-unwinding risk measure from the currency option pricing model, coupled with the identification of high-interest-rate currencies’ heightened susceptibility to position-unwinding risk, underscores the nuanced relationship between interest rate differentials, currency volatility, and global currency skewness risk.

Moreover, the decomposition of carry trade payoffs into sovereign credit premium, interest rate differentials, and expected exchange rate depreciation brings to light the profound influence of sovereign credit premia and market risk sentiment on cross-sectional variations in carry trade excess returns.

This comprehensive investigation not only showcases the multifaceted nature of the forward premium puzzle but also unveils the substantial impact of sovereign default risk on currency momentum and volatility risk premium portfolios, offering a wealth of insight into the intricate interplay of fundamental and market-driven factors shaping currency market dynamics.

Related Reading:

Momentum Effects in the Cryptocurrency Market after One-Day Abnormal Returns

Constructing Cointegrated Cryptocurrency Portfolios for Statistical Arbitrage

FAQ

Q1: What is the main focus of the research paper “Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia” by Huichou Huang and Ronald MacDonald?

A1: The main focus of the research paper is to provide a comprehensive framework for analyzing currency carry trade portfolios and their associated risks. The study specifically delves into the derivation of a position-unwinding risk measure from the currency option pricing model and explores the linkage between interest rate differentials, currency volatility, and global currency skewness risk. Additionally, the paper decomposes carry trade payoffs into sovereign credit premium, interest rate differentials, and expected exchange rate depreciation to analyze currency risk premia.

Q2: What is the position-unwinding risk measure, and how is it derived?

A2: The position-unwinding risk measure is derived from the currency option pricing model. It serves as an indicator of the likelihood of position unwinding in currency carry trade portfolios. The measure is driven by interest rate differentials and currency volatility and is highly correlated with global currency skewness risk. Essentially, it quantifies the risk associated with the unwinding of positions in currency carry trades, providing insights into the potential challenges and vulnerabilities in these portfolios.

Q3: What does the research reveal about the exposure of high-interest-rate currencies to position-unwinding risk?

A3: The research reveals that high-interest-rate currencies exhibit higher exposure to position-unwinding risk compared to low-interest-rate currencies. This finding suggests that currencies with higher interest rates are more susceptible to the risks associated with the unwinding of positions in currency carry trades. The study sheds light on the nuanced relationship between interest rate differentials and position-unwinding risk.

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