Financial Intermediary Constraints and Carry Trade Return

According to the literature on intermediary asset pricing, the financial well-being of the intermediary sector significantly influences the performance of financial assets. This paper delves into the role of financial intermediary balance sheets in contributing to carry trade returns. Given the dual role of financial intermediaries as providers of funding to carry traders and active participants ready to capitalize on carry trade returns in currency markets, we expect the financial conditions of intermediaries to be even more important for currency carry trade returns.The presence of a binding balance sheet constraint as a friction in financial intermediation can impose restrictions on the lending activities of intermediaries to carry traders and other financial institutions, and can also lead to a reduction in their own investment positions as carry traders. Hence, we explore various channels through which these constraints on financial intermediaries can influence the returns to carry trades. Our analysis demonstrates that a portion of the carry trade returns can be attributed to compensating for the limitations on the additional risk-bearing capacity of financial intermediaries associated with both funding and investment currencies in a carry trade strategy.