Spillovers of currency carry trade returns, market risk sentiment, and U.S. market returns

• This paper examines the link between spillovers of currency carry trade returns and U.S. market returns.
• Empirical results present a high magnitude of spillover effects of currency carry trade markets.
• Empirical results show a significantly positive relationship between spillovers of currency carry trade returns and subsequent market returns.
• The impact of spillovers of currency carry trade returns on subsequent market returns is stronger in bear markets.
• The spillovers of currency carry trade returns affect the subsequent transition probabilities of market returns.

This paper examines the link between spillovers of currency carry trade returns and U.S. market returns. Following Tse and Zhao (2012), this paper hypothesizes that the magnitude of spillovers of currency carry trade returns is positively correlated with market risk sentiment and, therefore, has an impact on market returns. Using the G10 currencies and S&P 500 index futures, the empirical results present a high magnitude of spillover effects of currency carry trade markets. The empirical findings also show a significantly positive relationship between spillovers of currency carry trade returns and subsequent market returns. Furthermore, the results indicate that this relationship is stronger in bear markets than in bull markets. Finally, our findings show that spillovers of currency carry trade returns significantly affect the subsequent transition probabilities of market returns.