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Bank default risk and carry trade profit

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  • Kim, Daehwan
  • Song, Chi-Young

Abstract

Currency carry trades–buying high-deposit-rate currencies and selling low-deposit-rate currencies–earn positive excess returns over time. The literature has heretofore explained this phenomenon based on currency differences. We examine the possibility that the bank default risk of destination countries contributes to positive carry trade profit. We measure the bank default risk of a country by averaging the distance to default–an option-pricing-based measure of default risk–of individual banks in that country. The average distance to default is strongly correlated both with deposit rate and with currency excess return. Also, “distance-to-default premium” explains a significant part of the time variation in carry trade profit.

Suggested Citation

  • Kim, Daehwan & Song, Chi-Young, 2015. "Bank default risk and carry trade profit," Economics Letters, Elsevier, vol. 130(C), pages 117-119.
    • Handle: RePEc:eee:ecolet:v:130:y:2015:i:c:p:117-119
    DOI: 10.1016/j.econlet.2015.03.018
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    References listed on IDEAS

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    1. Eichenbaum, Martin & Rebelo, Sérgio & Burnside, Craig & Kleshchelski, Isaac, 2006. "The Returns to Currency Speculation," CEPR Discussion Papers 5883, C.E.P.R. Discussion Papers.
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    5. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2009. "Carry Trades and Currency Crashes," NBER Chapters, in: NBER Macroeconomics Annual 2008, Volume 23, pages 313-347, National Bureau of Economic Research, Inc.
    6. Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2011. "Do Peso Problems Explain the Returns to the Carry Trade?," The Review of Financial Studies, Society for Financial Studies, vol. 24(3), pages 853-891.
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    Cited by:

    1. Seungho Baek & Jeong Wan Lee & Kyong Joo Oh & Myoungji Lee, 2020. "Yield curve risks in currency carry forwards," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(4), pages 651-670, April.

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    More about this item

    Keywords

    Carry trade profit; Bank default risk; Distance to default;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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