Downside Market Risk of Carry Trades
Carry trades consistently generate high excess returns with high Sharpe ratios, but are subject to crash risk. I propose a new factor - the downside market factor - to explain the high currency returns. I show that the crashes happen systematically in the worst states of the world, when the stock market goes down or a disaster happens, and when the marginal utility of wealth is high. High-interest currencies have significantly high downside market betas and significantly negative coskewness with the stock market, while low-interest currencies can serve as a hedging instrument against the downside market risk. The differences in downside betas and coskewness of currency portfolios, sorted by the nominal interest rate, can explain their returns much better than the differences in standard market betas or consumption betas. GMM estimates of the downside beta premium are similar in the currency and stock markets, statistically significant and close to its theoretical value. I cannot reject the hypothesis that the downside market risk is priced similarly in the currency and stock markets.