Carry Trade, Forward Premium Puzzle and Currency Crisis

Recent many empirical studies have argued that currency carry trade have been a driving force behind exchange rate movements, and have explained the latest financial crisis of 2007-2009 in terms of a sudden, massive reversal of carry trade positions. The aim of this paper is to provide one potential theoretical explanation for questions why currency carry trade becomes profitable, and why a sudden unwinding of carry trade is caused. We propose a new behavioral model of currency bubbles and crashes. We consider that investors trade two currencies: the domestic currency, and the foreign currency. Investors are divided into two groups, the rational investors and the carry traders. The rational investors maximize their expected utility of their wealth in the next period. Carry traders maximize their random utility of binary choice: investing the domestic currency or investing the foreign currency. We demonstrate that carry-traders’ herd behavior, which follows the behavior getting a majority, gives cause to a currency bubble, and their carry trading prolongs bubble. However, depreciation of funding currency slows down as the carry-trader’s behavior approaches to a stationary state, so that the return on carry trade predicted by carry traders begins to decrease in the second half of bubble. We demonstrate that decreasing the return on carry trade predicted by carry traders lead to currency crash. Our model also gives a plausible explanation on the forward premium puzzle.