The tail risk premia of the carry trades

• We study the return to the carry trade in an asset pricing framework.
• We show that the return to the carry trade might be a compensation for tail risks.
• Tail risks might be understood as the interaction of the moments of the distribution of returns.
• We show that the interaction of moments rather than the moments alone seems to drive investor behavior.
• This makes sense since funding limits are defined on the back of tail risks measures (VaR) and not on the moments alone.

We study the relationship between the excess returns of portfolios invested in carry trade positions and an innovative global tail risk factor. We find that high interest rate currencies are related to innovations in global currency tail risk. They deliver low returns in times of unexpected high tail risk and high returns in times of unexpected low tail risk suggesting a standard Asset Pricing Theory approach to explain the returns to the carry trade. Our tail risk factor can be understood as the interaction of moment-based factors such as volatility, skewness and kurtosis. Our results tend to indicate that the interaction of moments, i.e. tail risk, rather than the moments alone drives investor behavior. This makes sense since the ultimate risk for carry traders is to reach their funding limits which are set, because of the regulations, on the back of tail risk statistics (Value at Risk) and not simply on the back of the volatility, the skewness or the kurtosis alone. The result holds in other cross-sections of currencies and whether the global tail risk indicators are estimated in the currency, the equity or the bond market.