Impact of Macroeconomic Surprises on Carry Trade Activity

Can official news and policy announcements affect foreign exchange speculation? This paper investigates the impact of macroeconomic surprises on risk perceptions of carry traders and the size of their overall positions. Unlike much of the previous literature, we are able to identify a significant impact of macroeconomic surprises on foreign exchange volatility of JPY/USD even at low (daily) frequency. We use information gleaned from risk reversal contracts (tails of the implied returns distribution) during the period when concerns about sharp yen appreciation were particularly high, hence more likely to show up in the price of risk. We also consider a broader set of U.S. and Japanese news than previous work, focusing on the announcements with particularly large surprise components to them. Overall, we find that macroeconomic news is an important determinant of risk reversals during periods of heavy carry trade volume, particularly when the cost of hedging against large yen appreciation is increasing. The results are more supportive of the trade-balance flow channel over portfolio-balance or monetary channel of exchange rate determination during the sample period. Specifically, Japan (U.S.) macro news that worsen (improve) the trade balance generally are associated with less perceived risk of sharp yen appreciation, as reflected in the value of risk reversals. Moreover, there is a close link between risk reversals and non-commercial futures positions. We calculate a substantial effect of macroeconomic news on carry trade activity, with risk reversals (the cost of hedging) as the transmission mechanism