Impact of macro-economic surprises on carry trade activity

Can official news and policy announcements affect foreign exchange speculation? A widespread speculative strategy in foreign exchange markets is carry trade. This paper explores the links between macroeconomic news and foreign exchange options to identify macro-economic fundamentals most relevant to the pricing of downside risk - measured by risk reversals options contracts - to carry trade activity. Focusing primarily on the Japanese yen carry trade, we identify a significant impact of macro-economic surprises on dollar/yen risk reversals. The effect is sizeable, with news related to bilateral trade balance of particular concern. Moreover, there is a close link between risk reversals and speculative futures positions in Japanese yen. This allows us to quantify a substantial effect of macro-economic news on carry trade activity, with the cost of hedging as the transmission mechanism. (C) 2012 Elsevier B.V. All rights reserved.