Job Market Paper:

What Carries the Carry Trade?

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The yen/dollar exchange rate and the credit spread are found to be co-integrated. We link the relationship to the carry trade and its eventful unwinding by doing the threshold co-integration estimation and cross-currency comparisons. To provide a structural explanation for the connection, we build a partial equilibrium model based on the leverage cycle theory. Collateral capacity of the foreign currency is adjusted to balance the pricing difference between the foreign currency suppliers and buyers. Exchange rate movements are therefore connected to the credit spread through the cyclical collateral adjustment channel. We thus illustrate that the leverage cycle is one possible source of the time-varying risk premium for holding foreign currencies.