Carry Trades and Sovereign CDS Spreads: Evidence from Asia‐Pacific Markets

Abstract

This article extends the current literature on currency carry trades by investigating the first and second moment interactions between carry trade returns and changes in sovereign credit default swap spreads. Using a VAR‐EGARCH model and a sample of nine Asia‐Pacific currencies, we examine the relation between sovereign spreads and carry trade returns with and without the inclusion of the 2008 global financial crisis period. Our results show that carry trade returns and sovereign spread changes are negatively correlated, with Granger causality running in both directions. We also find significant volatility spillover effects. High conditional correlation between the currency component of carry trades and sovereign spreads is documented, which is amplified if the crisis period is considered. Global risk affects carry trade volatility more during turbulent periods. © 2014 Wiley Periodicals, Inc. Jrl Fut Mark 35:1067–1087, 2015