Carry trades consistently generate high excess returns with high Sharp ratios, but are subject to crash risk. I take a closer look at the link between the carry trade returns and the stock market to understand the risks involved and to determine when and why currency crashes happen. Every period, I sort currencies of developed and emerging economies by their interest rates and form portfolios to diversify the idiosyncratic risk. First, I find a strong negative relationship between portfolio returns and skewness of exchange rate changes. In fact, skewness and coskewness with the stock market have a much greater explanatory power in the cross-section of excess returns than consumption and stock market betas. But separating the market beta into upside and downside betas improves the validity of the CAPM significantly. Downside beta has a much greater explanatory power than upside beta, and it correlates with coskewness almost perfectly. This means that carry trades crash exactly in the worst states of the world, when the stock market goes down. After controlling for country risk, the downside beta premium in the currency market is comparable to that in the stock market and equals 2-4 percentage points p.a. I also find that country risk proxies well for the downside beta and skewness. This suggests that there is unwinding of carry trades and a “flight to quality” when the stock market plunges, and that lower interest rate currencies serve as a “safe haven”. Finally, I estimate even higher downside betas of the top portfolios and I find an even greater explanatory power of the downside beta in the early 2000s. The growing volume of carry activities might have contributed to the closer link between the currency and the stock markets.
The paper deals with the problem of determining optimal position in foreign currency for an international investor. In the first part of the paper effectiveness of international diversification is considered. In the second part the author considers modern models designed for determining optimal position in currency for international investor depending on his aims (risk minimization, financial wealth maximization). The author suggests ways to improve wealth maximization model, aimed both to increase the quality of approximation of processes of changing prices on financial markets and to enhance the quality of modeling investor’s preferences by including coherent or spectral risk measures in financial wealth maximizing function. When standard deviation is used to model investor’s preferences it is assumed that the value of the portfolio for investor depends equally on positive and negative returns. Actually investor is more responsive to losses than to a large positive return. This fact is of great importance for investment funds managers seeking to minimize the outflow in times of economic instability. To improve the quality of approximation of financial assets prices the author suggests using dynamic conditional correlation matrix to model different assets return interdependence. As Russian stock market is quite risky (in comparison with developed countries capital markets) the author considers it appropriate to use the processes with random jumps for modeling stock prices.
World fi nancial crisis and increased volatility of major economic indicators raised attention to the problem of fi nancial risk management in corporations, and to the possibilities of fi nancial derivatives usage for hedging. In perfect markets hedging by means of derivatives allows corporations to mitigate fi nancial risks allowing for minimum costs. Current paper examines factors that restrict usage of derivatives for hedging currency risks by corporations on Russian fi nancial market. It is concluded that on Russian market it is reasonable to use internal facilities as basic method of currency risk management: asset/liability management, regulation of debt
currency structure, diversifi cation, etc. Derivatives should be used in addition to these facilities in very limited volumes for hedging the most predictable sources of risk.