Does previous carry trade position affect following investors' decision-making and carry returns?

This paper builds a two-country model to investigate the relationship between carry trade activity and carry trade return. The two-country model finds that previous carry trade position could positively affect current carry return and current carry trade scale. This positive relationship fosters the asset bubble of high-yielding currency, and the potential for huge losses could also make the carry trader unwind the carry trade position. Based on carry trade panel data from 22 countries and regions, this paper studies the relationship empirically through a panel vector autoregression model. The empirical results find that carry trade position has a significant positive relationship with carry return and carry trade position in following periods. Also, the empirical results suggest that foreign exchange risk could negatively affect carry return and carry trade position. Once the foreign exchange risk increases, carry traders choose smaller carry trade positions.

Automated summary

This paper investigates the relationship between carry trade activity and carry trade return by building a two-country model and using panel data. The study finds that previous carry trade position positively affects current carry return and trade scale, while foreign exchange risk has a negative impact on carry return and trade position.