Skip to content
GetProfitable
Search

Carry Trades and Currency Crashes

Read the paperopens www.nber.org in a new tab

What they found

The authors document that carry trade returns are negatively skewed: high-interest currencies go up the stairs and down the elevator. Using data on eight major currencies from 1986 to 2006, they show that the skewness is linked to speculator positioning (when futures positioning in a carry currency is crowded, subsequent crash risk rises), that carry currencies crash when the VIX spikes and funding liquidity dries up, and that options on carry currencies price this crash risk through risk reversals. The unwinding of crowded carry positions amplifies the crash.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Contango and backwardationTwo futures curves against contract expiry: one rising above spot, one falling below it.The same commodity, priced for delivery at different dates.78.0076.0074.0072.0070.00Futures pricespot+1m+2m+3m+4m+5m+6mMonths until the contract expiresspot price74.00CONTANGOlater contracts cost more than spotBACKWARDATIONlater contracts cost less than spot
Contango and backwardation. A futures curve shows what buyers will pay for delivery in one month, two months and so on. When later contracts cost more than the spot price the curve is in contango; when they cost less it is in backwardation.

What you can use

  • Carry earns steadily and then loses months of gains in days; the return distribution is the opposite of a lottery ticket.
  • Crowded carry positioning (visible in futures data) predicts larger crashes; the exit is narrow when everyone is on the same side.
  • Carry crashes coincide with VIX spikes and liquidity stress, so carry is correlated with everything else risky in the worst moments.

Caveats

Sample ends just before the 2008 crash, which then confirmed the thesis dramatically. Positioning data from CFTC futures covers only part of the carry market.

Tags: forex, carry, crashes, skewness, liquidity

Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.