Does Betting On Currencies Make Them Riskier? The Carry Trade and Endogenous Risk

I study the role of arbitrage in creating non-fundamental foreign exchange movements. I focus on the carry trade, a dominant currency arbitrage strategy and a well-known violation of uncovered interest parity. I argue that if investor capital is exposed to systematic factors, the risk is propagated to the currencies they trade. I present a three-proposition model in which currencies inherit such arbitrage-driven risk only when carry trade activity is widespread, implying the endogeneity of the carry trade’s observed return. Considering 15 advanced and 32 emerging market currencies, I find that the interest rate differential of a carry trade predicts a measure of risk due to shocks to investor funding, and controlling for liquidity magnifies the effect. My results strongly support the model in which the carry trade generates arbitrage-driven risk by inducing exchange rate movements. My findings imply that anomaly returns of the carry trade persist in part because the arbitrage strategy itself generates risk. My results indicate that currencies are vulnerable to more than just macroeconomic fundamentals. This suggests that some emerging markets may benefit from managing their exchange rates to constrain arbitrage-driven risk.