See discussions, stats, and author profiles for this publication at: Carry Trades and Tail Risk of Exchange Rates Article in Staff Studies · August 2016 DOI: 10.4038/ss.v44i1-2.4694 CITATIONS 0 READS 631 1 author: Chanaka Ganepola The University of Manchester 3 PUBLICATIONS 7 CITATIONS SEE PROFILE All content following this page was uploaded by Chanaka Ganepola on 19 June 2017. The user has requested enhancement of the downloaded file.
69 CENTRAL BANK OF SRI LANKA Carry Trades and Tail Risk of Exchange Rates Chanaka N. Ganepola 1 Abstract Historically, Carry trades have been a success story for most investors and a major source of funds for emerging economies maintaining higher interest rates. Therefore it is 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 the high return portfolio and short in the 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, this paper finds that, the 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. Key Words: Heavy-tailedness, Carry Trade, Value-at-Risk JEL Classification: F30, F37, G15 1 I sincerely thank Dr. Pasquale Della Corte and Mr. Xi Chen of Imperial College, London, and Dr. Sumila Wanaguru of the Central Bank of Sri Lanka for their valuable guidance and feedback. The author is also thankful to anonymous reviewers. [email protected]
Staff Studies - Volume 44 Numbers 1 & 2 CENTRAL BANK OF SRI LANKA 70 1. Introduction Carry trade strategy is a popular investment strategy when it comes to Foreign Exchange trading. According to Uncovered Interest Parity (UIP), the exchange rates will eliminate the returns received from the difference of interest rate across the respective countries. A carry trade can also be fulfilled via buying a foreign currency forward when it's at a forward discount or vice versa. The main idea is to borrow the low yielding currencies and invest in the high yielding currencies, thereby earning the spread in between. Even though theoretically we assume an arbitrage free environment, reality says otherwise Fama (1984) confirms that regression of exchange rate changes with respect to the change in interest rate yields a value less than 1, while it has to be equal to 1 according to UIP. That is, the returns on the high yielding currency does not equal the return on the low yielding currency taken with the expected appreciation of the foreign currency. Fama (1984) recognizes this flaw of UIP as the "forward premium puzzle". Despite the historical evidence of high returns, the carry trade positions will be exposed to higher risk as the volatility of the currency increases. The borrowers will try to close their debt positions against the respective lenders if the borrowing currencies start appreciating. Moreover, academic evidence indicates that carry trades often suffer large losses during insecure markets conditions, even though such trades perform well in conducive markets (Farhi et al . 2013, Liu et al . 2012). In practice, developing countries account for higher interest rates on investments and therefore an attractive carry trade opportunity for the investors. On the other hand, investors are more concerned about the risk of the opportunity despite the attractiveness of the opportunity. In this context, the question arises whether the carry trade returns influence the respective crash risk. Further it is observable that most active carry traders are present in major emerging market currencies. Therefore if one currency crashes, there exists a high probability that it might spread to other surrounding economies. Despite the strength of the economy, the regulators of financial institutions are more concerned with the extreme events which might force the liquidation of the financial institution leading to an imbalance in the financial system. Therefore, this paper intends to focus this research specifically on tail risk which is frequently used by regulators in order to access the funding limits of the investors. Moreover, should the investors be concerned about the tail risk at all when they invest in high interest rate currencies? The most trivial way to estimate tail risk is to assume that returns are normally distributed. However, due to the inefficiency of this assumption, later studies 2 utilised more heavy tailed distributions such as student-t. Both these methods are most likely to either 2 Please refer to Kole and Verbeek (2006).
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