Violations of Uncovered Interest Rate Parity and International Exchange Rate Dependences (original) (raw)
Related papers
Upside and Downside Risk Exposures of Currency Carry Trades via Tail Dependence
SSRN Electronic Journal, 2000
Currency carry trade is the investment strategy that involves selling low interest rate currencies in order to purchase higher interest rate currencies, thus profiting from the interest rate differentials. This is a well known financial puzzle to explain, since assuming foreign exchange risk is uninhibited and the markets have rational risk-neutral investors, then one would not expect profits from such strategies. That is, according to uncovered interest rate parity (UIP), changes in the related exchange rates should offset the potential to profit from such interest rate differentials. However, it has been shown empirically, that investors can earn profits on average by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, whilst allowing for any losses from exchanging back to their domestic currency at maturity. This paper explores the financial risk that trading strategies seeking to exploit a violation of the UIP condition are exposed to with respect to multivariate tail dependence present in both the funding and investment currency baskets. It will outline in what contexts these portfolio risk exposures will benefit accumulated portfolio returns and under what conditions such tail exposures will reduce portfolio returns.
SSRN Electronic Journal, 2000
The currency carry trade is the investment strategy that involves selling low interest rate currencies in order to purchase higher interest rate currencies, thus profiting from the interest rate differentials. This is a well known financial puzzle to explain, since assuming foreign exchange risk is uninhibited and the markets have rational risk-neutral investors, then one would not expect profits from such strategies. That is uncovered interest rate parity (UIP), the parity condition in which exposure to foreign exchange risk, with unanticipated changes in exchange rates, should result in an outcome that changes in the exchange rate should offset the potential to profit from such interest rate differentials.
Carry trade and foreign exchange rate puzzles
European Economic Review, 2013
This article demonstrates that carry trade is part of the explanation of foreign exchange rate puzzles. We introduce carry traders in a heterogeneous agent model in addition to fundamentalists and chartists. Our model has the ability to produce the stylized facts observed in empirical exchange rates, such as heavy tails, excess volatility, and volatility clustering, as well as the negative relationship between market volatility and carry trade activity. We find that the interaction between carry traders and chartists provides an explanation for the forward premium puzzle. This effect is strengthened by chartists, who extrapolate the trend induced by carry trade.
Uncovered Interest Rate Parity, Carry Trade, and Country Equity Return Differentials
Global Economy Journal, 2018
This paper applies a mixed effect model to investigate the relationship between international equity returns and forward discount sorted currency returns from three base currencies (i. e., US dollar, euro, and pound sterling). Empirical results using the portfolio approach show that high-interest rate currencies co-move positively while low-interest rate currencies co-move negatively, suggesting that foreign equity excess returns can help to explain investment in currency markets, providing a partial resolution to the uncovered interest parity conundrum. Furthermore, we show that global equity market returns, volatility, and liquidity correlate well with currency returns.
The Uncovered Interest Rate Parity Anomaly And Foreign Exchange Market Turnover
International Business & Economics Research Journal (IBER), 2012
The uncovered interest rate parity (UIP) anomaly is that high interest rate currencies appreciate, rather than depreciate, against low interest rate currencies. We show that the UIP anomalies apparent in six major currency pairs have diminished over our 1995-2010 sample period. We further show that the observed decline in deviations from UIP is associated with the substantially higher transaction volume now present in the foreign exchange markets. We interpret our findings as consistent with the proposition that the UIP anomaly dissipates as the foreign exchange markets become more efficient.
Carry Trade and Momentum in Currency Markets
We examine the empirical properties of the payo!s to two popular currency speculation strategies: the carry trade and momentum. We review three possible explanations for the apparent profitability of these strategies. The first is that speculators are being compensated for bearing risk. The second is that these strategies are vulnerable to rare disasters or peso problems. The third is that there is price pressure in currency markets.
Common Risk Factors in Currency Markets
2008
Currency excess returns are highly predictable and strongly counter-cyclical. The average excess returns on low interest rate currencies are 4.8 percent per annum smaller than those on high interest rate currencies after accounting for transaction costs. A single return-based factor, the return on the highest minus the return on the lowest interest rate currency portfolios, explains the cross-sectional variation in average currency excess returns from low to high interest rate currencies. In a simple affine pricing model, we show that the high-minus-low currency return measures that component of the stochastic discount factor innovations that is common across countries. To match the carry trade returns in the data, low interest rate currencies need to load more on this common innovation when the market price of global risk is high.
The Returns to Currency Speculation in Emerging Markets
American Economic Review, 2007
The carry trade strategy involves selling forward currencies that are at a forward premium and buying forward currencies that are at a forward discount. We compare the payo¤s to the carry trade applied to two di¤erent portfolios. The …rst portfolio consists exclusively of developed country currencies. The second portfolio includes the currencies of both developed countries and emerging markets. Our main empirical …ndings are as follows. First, including emerging market currencies in our portfolio substantially increases the Sharpe ratio associated with the carry trade. Second, bid-ask spreads are two to four times larger in emerging markets than in developed countries. Third and most dramatically, the payo¤s to the carry trade for both portfolios are uncorrelated with returns to the U.S. stock market.