Abstract
In this study, we show that currency option prices possess predictive powers on future currency carry trade crashes. We then propose a new currency carry trade strategy that hedges carry trade crash risks only when crashes are predicted. We find that the new conditionally-hedged strategy not only hedges crash risks but also offers a significant increase in profit, compared to the conventional currency carry trade strategy during the hedging periods. The superiority of the new conditionally-hedged carry trade relative to the conventional carry trade is robust to various specification changes. Our results oppose the argument that excess returns from a carry trade are compensation for crash risk exposures.
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