The Crash Risk Premia of Efficient Carry Trades

Carry trade strategies in which investors sell forward currencies that are at a forward premium and buy forward currencies that are at a forward discount are, on average, profitable. According to the uncovered interest rate parity they should not. A risk premia story might justify the high returns to the carry trades. In this paper we study the relationship between the cross section of excess returns of portfolios invested in carry trade positions and a renewed set of candidate risk factors. Asset pricing theory applies to the currency market: those currencies that have larger loading on risk, especially crash risk, offer a larger mean return in compensation. Especially, we show that crash risk as measured by quantile based statistics such as VaR or CVaR prices better the return to the carry trades than moments based factors such as standard deviation or skewness. This result holds at the portfolio level and at the single currency level. As a result, we show that carry trade strategies that take account of the dispersion of interest rates dominate strategies in which bets are normalized