Solvency Risk Premia and the Carry Trades
A new financial research paper related to:
#5 – FX Carry Trade
Title: Solvency Risk Premia and the Carry Trades
This paper shows that currency carry trades can be rationalized by the time-varying risk premia originating from the sovereign solvency risk. We find that solvency risk is a key determinant of risk premia in the cross section of carry trade returns, as its covariance with returns captures a substantial part of the cross-sectional variation of carry trade returns. Importantly, low interest rate currencies serve as insurance against solvency risk, while high interest rate currencies expose investors to more risk. The results are not attenuated by existing risks and pass a broad range of various robustness checks.
Notable quotations from the academic research paper:
"Overall, the cumulative evidence points to time-varying risk premia as the pervasive source of the carry trade returns and to the forward premium puzzle not being without costs. Nonetheless, the identification of an appropriate risk premia that explains the carry trade profitability remains an ongoing debate. This paper provides new evidence in favor of sovereign solvency being a potential source of risk in currency market.
This paper contributes to current debate by revealing a new economic-based time-varying risk premia in the currency market that depends upon a country’s solvency. We argue that the financial capacity of the economy, captured by the solvency measures, incites the differences in average carry trade excess returns. In other words, the profitability of currency carry trades can be rationalized by the time-varying risk premia that originate from the sovereign solvency risk. Consistently, we find that high interest rate currencies demand a higher risk premium, as they deliver low carry trade returns at times of high solvency risk, therefore exposing investors to more risk, whereas low interest currencies are a hedge against the solvency risk.
In this paper we assume risk premium is a function of financial solvency of the economy, defined by either a ratio of foreign debt to economy’s earning ability (henceforth, the solvency measure), or a ratio of balance of the current account to the estimated aggregate of total exports of goods and services, or aggregated financial solvency index. Risk premium is then represented by an increasing convex function of one of these measures. In the most of our analysis, we consider external debt service capacity measured by the gross foreign debt-to-output ratio as a measure of solvency of the country.
We perform portfolio sorts on forward discounts and the solvency measure, identify risk factor as the returns on zero-cost long-short strategy between the last and first solvency-sorted portfolios and label it IMS, for indebted-minus-solvent economies. The IMS factor explains the substantial part of the cross-sectional variation in carry trade portfolios, exhibiting monotonically increasing factor loadings and significant prices of risk, consistent with risk premia explanation. Moreover, the factor is empirically powerful in various model specifications and sample splits, prices different test assets, stands out horse races with other currency-specific risk factors, robust against an alternative funding currency (the Japanese Yen) and alternative solvency measure specifications, and passes several other robustness checks. Taken collectively pointing to the solvency risk factor being an effective tool for pricing the cross-section of carry returns."
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