Crowds, Crashes, and the Carry Trade

Currency carry trades exhibit sudden and extreme losses. A popular explanation is that these losses are to some extent driven by leveraged carry trade speculators amplifying negative shocks through forced unwinding of their positions. A testable implication is that the likelihood and intensity of large carry trade losses (crashes) increases with the level of carry trade activity (crowdedness). To test it, I develop a measure of crowdedness based on daily abnormal currency return correlation among the target currencies. This measure is related to other indicators of FX market activity. I show that between 40% and 50% of the largest carry trade losses occur in periods of high crowdedness. I further demonstrate that high levels of crowdedness double the probability of realizing an extreme carry trade loss after controlling for FX volatility, FX liquidity, equity volatility and funding liquidity. The level of crowdedness amplifies negative carry trade returns and has no effect on the positive ones. The results hold at multiple time horizons.  

PRESENTED AT: Aalto University, Amsterdam Business School, BI Norwegian Business School, EFA 2018, FMA 2018, HEC Montréal,  Lund University, NFA 2017, Norwegian School of Economics, Nova School of Business and Economics, Stockholm Business School, Stockholm School of Economics, Universidad Carlos III de Madrid, University of Georgia, University of Gothenburg, University of Münster University of Texas at Dallas, Vienna Symposium on Foreign Exchange Markets, Vrije Universiteit Amsterdam, Warwick Business School. 

How Sovereign is Sovereign Credit Risk? Global Prices, Local Quantities.

(with Patrick Augustin, Marti G. Subrahmanyam and Davide Tomio)
Abstract:  The sovereign default insurance market is concentrated and strongly intermediated, with fluctuations in insurance prices being dominated by common, global sources of risk. Yet, we find that insurance quantities are primarily explained by country-specific factors. Using net positions in sovereign default insurance contracts for 60 countries from October 2008 to September 2015, we find that the stock of a country's debt, and the size of its economy, explain 75% of cross-country differences in net insured interest. Debt issuance significantly explains variation in its dynamics. Our findings are informative for the regulatory debate on the market for sovereign default insurance.

PRESENTED AT:  AFA 2018, Bank of Italy, China International Conference in Finance, IFSID Conference on Structured Products and Derivatives, Kiel Workshop on Empirical Asset Pricing, 2016 HEC-McGill Winter Finance Workshop, New York University Stern School of Business, Stockholm School of Economics.

Short Selling Equity Exchange Traded Funds and its Effect on Stock Market Liquidity*

(with Egle Karmaziene)  
Abstract: We examine short selling of equity exchange traded funds (ETFs) using the September 2008 short-sale ban. Contrasting the previously-documented contractions in other bearish strategies, we demonstrate that during the ban the short sales of the largest and the most liquid ETF, the S&P 500 Spider, significantly increased. We offer evidence that it was driven primarily by short sellers circumnavigating the ban. We also document a concurrent increase in the supply of ETF shares suggesting that they can be created to accommodate short-sales. Additionally, we show that the detrimental effect of regulatory short-sale constraints on stock liquidity was up to 10% less severe for the constituents of the Spider. Our results suggest that short-sales of ETFs are a viable substitute for directional short-sales of individual stocks. They also highlight a novel channel through which ETFs can have a positive effect on the liquidity of its underlying securities.

*The paper was previously circulated under the title “Beware of the Spider: Exchange Traded Funds and the 2008 Short-Sale Ban

PRESENTED AT: Bank of Lithuania, Columbia Business School, International Monetary Fund, McGill University, International Risk Management Conference, Nordic Finance Conference, Stockholm School of Economics, University of Cape Town. 

Industry Coverage: "The short on shorting ETFs: The art of create to lend." Eurex Group Institutional Insight, May 2014. 

Work in Progress

Hedge Funds and Financial Intermediaries

(with Magnus Dahlquist and Erik Sverdrup)
Hedge funds and financial intermediaries are connected through their prime brokerage relationship. Our results indicate that the effect of prime brokers on hedge fund returns stems primarily from the systematic component. Using the network structure of prime brokers and their hedge fund clients, we identify the key financial intermediaries in the sector. We find that the financial intermediary risk, as measured by the covariation between the fund return and the return of a portfolio of key prime brokers, is a strong determinant of the cross-section of hedge fund returns. A portfolio of hedge funds with high intermediary risk exposure outperforms a low-exposure fund portfolio by around 7% per year on a risk-adjusted basis. In contrast, we do not find a significant link between the idiosyncratic returns of individual prime brokers and their clients.

The Benchmark Currency Stochastic Discount Factor

(with Erik Sverdrup)
The question of what the appropriate pricing kernel is for pricing the positive expected excess returns for investments in high interest rate currencies and the negative expected excess returns for investments in low interest currencies remains open in the literature. A number of competing candidate currency pricing kernels currently exist. We use a relative entropy minimization approach to extract the most likely pricing kernel to price the interest rate sorted currency portfolios out-of-sample. This pricing kernel delivers superior cross-sectional fit and smaller pricing errors than the currently available currency return pricing models. Moreover, our pricing kernel offers an intuitive benchmark to which the existing candidate currency pricing kernels can be compared and presents a tractable framework within which we survey the existing literature on currency risk premiums.