Upside and Downside Risk Exposures of Currency Carry Trades via Tail Dependence

TL;DR

This paper investigates the tail dependence risks in currency carry trades, analyzing how extreme market movements in funding and investment currencies impact the profitability and risk profile of these strategies.

Contribution

It introduces a novel analysis of tail dependence effects in currency carry trades, highlighting conditions that amplify or mitigate portfolio risks due to extreme exchange rate movements.

Findings

Tail dependence significantly affects carry trade risks.

Extreme market movements can both enhance and reduce returns.

Risk exposures depend on market conditions and currency basket compositions.

Abstract

Currency carry trade is the investment strategy that involves selling low interest rate currencies in order to purchase higher interest rate currencies, thus profiting from the interest rate differentials. This is a well known financial puzzle to explain, since assuming foreign exchange risk is uninhibited and the markets have rational risk-neutral investors, then one would not expect profits from such strategies. That is, according to uncovered interest rate parity (UIP), changes in the related exchange rates should offset the potential to profit from such interest rate differentials. However, it has been shown empirically, that investors can earn profits on average by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, whilst allowing for any losses from exchanging back to their domestic currency at maturity. This paper explores the financial risk that trading strategies seeking to exploit a violation of the UIP condition are exposed to with respect to multivariate tail dependence present in both the funding and investment currency baskets. It will outline in what contexts these portfolio risk exposures will benefit accumulated portfolio returns and under what conditions such tail exposures will reduce portfolio returns.