In this paper we derive the measure of position-unwinding risk of currency carry trade portfolios from the currency option pricing model. The position-unwinding likelihood indicator is in nature driven by interest rate differential and currency volatility, and highly correlated with global currency skewness risk. We show that high interest-rate currencies are exposed to higher position-unwinding risk than low interest-rate currencies. We then provide a framework that decomposes carry trade payoffs into sovereign credit premium, interest rate differential, and expected exchange rate depreciation (overshooting) upon default components to analyze currency risk premia. We investigate the sovereign CDS spreads as the proxy for solvency of a state and find that high interest-rate currencies load up positively on sovereign default risk while low interest-rate currencies provide a hedge against it. Sovereign credit premia, as the dominant (country-specific) fundamental risk that drives market volatility (global contagion channel), together with position-unwinding likelihood indicator as the market risk sentiment, captures over 90% of cross-sectional variations of carry trade excess returns. In this context, the forward premium puzzle can be understood as a composite story of sovereign credit premia, global liquidity imbalances and reversal. We further reveal that sovereign default risk also explains large proportions of the cross sections of currency momentum (over 65%) and volatility risk premium (over 80%) portfolios.

Keywords: Carry Trades, Position-Unwinding Risk, Sovereign CDS Spreads, Currency Options, Forward Premium Puzzle

Continue reading here.