Carry Trades and Tail Risk of Exchange Rates

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.