Currency Carry Trades and Funding Risk

In this paper, we measure currency carry trade funding risk using stock market volatility and crash risk in Japan, the main funding currency country. We show that the measures of funding risk in Japan can explain 42% of the monthly currency carry trade returns during our sample period, 2000-2011. In addition, they explain 64% of the monthly foreign exchange volatility in our sample of ten main currencies, 28% of the speculators' net currency futures positions in Australian dollar versus Japanese yen, skewness in currency returns and currency crashes. We present a theoretical model that is consistent with these findings.