Are stock markets in Asia related to carry trade?

•We examine the relation between carry trade and four Asian stocks.•We find significant return causality from carry trade to stock markets.•We find significant bidirectional volatility spillovers between the two markets.•These effects are most significant during the 2008 financial crisis period.

This study examines the relationship between carry trade returns and those of stock markets, using daily data from January 1995 to December 2011, and evaluates volatility spillover for the Japanese, Australian, Indian and Korean stock markets, in order to assess cross-market linkages. We have the following main results. First, we find significant causality in returns from carry trade to the Asian stock markets. These effects are mostly visible during the 2008 financial crisis and still persist after the crisis period. Second, there is bidirectional volatility spillover effect between the currency carry trade and Asian stocks. As the stock-to-carry spillover exists in most stock markets during financial crisis, the carry trade market takes the leading role in the cross-market information transmission during the post-crisis period. Third, the traditional view that carry trades make bets with borrowed money on small differences in interest rate markets does not appear to hold. Carry trades also participate in betting on economic fundamentals in recent years, as shown by the Japanese stock market with low interest rate.