Impact of macroeconomic surprises on carry trade activity

Can official news and policy announcements affect foreign exchange speculation? A widespread speculative strategy in foreign exchange markets is carry trade. This paper explores the links between macroeconomic news and foreign exchange options to identify macroeconomic fundamentals most relevant to the pricing of downside risk – measured by risk reversals options contracts – to carry trade activity. Focusing primarily on the Japanese yen carry trade, we identify a significant impact of macroeconomic surprises on dollar/yen risk reversals. The effect is sizeable, with news related to bilateral trade balance of particular concern. Moreover, there is a close link between risk reversals and speculative futures positions in Japanese yen. This allows us to quantify a substantial effect of macroeconomic news on carry trade activity, with the cost of hedging as the transmission mechanism. ⺠Macroeconomic news impacts “tail risk” perceptions in JPY/USD. ⺠The results point to trade balance/flow model, often cited by practitioners. ⺠These results are robust to using CHF and AUD as alternative currencies. ⺠Speculators respond to currency risk hedging cost changes after macro releases. ⺠Macro news can translate in up to one third of yen speculative position changes.