Reinvestigating The Uncovered Interest Rate Parity Puzzle Via Analysis Of Multivariate Tail Dependence In Currency Carry Trades

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 the interest rate differentials. Given foreign exchange market equilibrium, the interest rate parity condition implies that the expected return on domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets.However, it has been shown empirically, that investors can actually earn profits 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 (or gains) from exchanging back to their domestic currency at maturity. Therefore trading strategies that aim to exploit the interest rate differentials can be profitable on average. The intention of this paper is therefore to reinterpret the currency carry trade puzzle in light of heavy tailed marginal models coupled with multivariate tail dependence features. We analyse the returns of currency carry trade portfolios adjusting for tail dependence risk. To achieve this analysis of the multivariate extreme tail dependence we develop several parametric models and perform detailed model comparison. It is thus demonstrated that tail dependencies among specific sets of currencies provide other justifications to the carry trade excess return and also allow us to detect construction and unwinding periods of such carry portfolios.

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The uncovered interest rate parity puzzle questions the economic relation existing between short term interest rate differentials and exchange rates. One would indeed expect that the differential of interest rates between two countries should be offset by an opposite evolution of the exchange rate between them, hence ruling out any limited risk profit opportunities. However, it has been shown empirically that this relation is not holding and accordingly has led, over the past two decades, to the reinforcement of a well-known trading strategy in financial markets, namely the currency carry trade. This paper investigates how highly leveraged, mass speculator behaviour affects the dependence structure of currency returns. We propose a rigorous statistical modelling approach using two complementary techniques in order to demonstrate that speculative carry trade volumes are informative in both the covariance and tail dependence of high and low interest rate currency returns, whereas the price based factors previously suggested in the literature hold little explanatory power. We add a new feature to the understanding of the link between the UIP condition and the carry trade strategy, specifically attributed to the large joint exchange rate movements in high and low risk environments.The appendices for this paper are available at the following URL: "http://ssrn.com/abstract=2638103" http://ssrn.com/abstract=2638103.

This note provides an overview of the uncovered interest parity assumption. It traces the history of the interest parity concept, summarizes evidence on the empirical validity of uncovered interest parity, and discusses the implications for macroeconomic analysis. The uncovered interest parity assumption has been an important building block in multiperiod and continuous time models of open economies, and although its validity is strongly challenged by the empirical evidence, its retention in macroeconomic models is supported on pragmatic grounds, at least for the time being, by the lack of much empirical support for existing models of the exchange risk premium.

This online appendix to "Violations of Uncovered Interest Rate Parity and International Exchange Rate Dependences" includes the copula density function for the Clayton-Frank-Gumbel mixture copula and the details for the likelihood based estimation of the multivariate currency basket log returns. Currency carry trade high and low interest rate baskets over time are shown. Further results for the copula parameter fits and associated dependence measures are then analysed. A description of the method used to calculate the confidence intervals for the covariance regression is given. Finally, the method used to interpolate the one month forward price curve is explained.The paper "Violations of Uncovered Interest Rate Parity and International Exchange Rate Dependences" to which these Appendices apply is available at the following URL: "http://ssrn.com/abstract=2638163" http://ssrn.com/abstract=2638163.

This paper provides an overview of the uncovered interest parity assumption. It traces the history of the interest parity concept, summarizes evidence on the empirical validity of uncovered interest parity, and discusses different interpretations of the evidence and the implications for macroeconomic analysis. The uncovered interest parity assumption has been an important building block in multiperiod models of open economies, and although its validity is strongly challenged by the empirical evidence, at least at short time horizons, its retention in macroeconomic models is supported on pragmatic grounds by the lack of much empirical support for existing models of the exchange risk premium.

This paper proposes a new explanationfor the UIP puzzle by analyzing a large number of cross-country bilateral exchange rates in two dimensions, cross-sectional and time-series. The exchange rates analyzed here includes a broad spectrum of developed and developing countries. The UIP relationship holds up well in cross-sectional analysis and the slope estimates remain largely between zero and one throughout the sample periods, with a few exceptions. There does not appear to be a well-publicized UIP puzzle for cross-sectional UIP. For time-series UIP, short-term (one month) UIP holds up well and UIP puzzle is largely confined to the key currencies. We introduce the key currency bias to explain the empirical failure of UIP in these cases. The key currency concept is a similar to the home bias for portfolio holdings. UIP seems to fail more often when a key currency is involved in the bilateral exchange rate relationship than when only non-key currencies are involved, especially when the key currency offers higher return on capital. This paper presents an empirical evidence for a state-dependent asymmetric response in exchange rate changes depending on the direction of the forward premium.

Uncovered interest parity (UIP) has been almost universally rejected in studies of exchange rate movements, although there is little consensus on why it fails. In contrast to previous studies, which have used relatively short-horizon data, we test UIP using interest rates on longer-maturity bonds for the G-7 countries. These long-horizon regressions yield much more support for UIP -- all the coefficients on interest differentials are of the correct sign, and almost all are closer to the UIP value of unity than to the zero coefficient implied by the random walk hypothesis. We then use a small macroeconomic model to explain the differences between the short- and long-horizon results. Regressions run on data generated by stochastic simulations replicate the important regularities in the actual data, including the sharp differences between short- and long-horizon parameters. In the short run from risk premium shocks in the face of endogenous monetary policy. In the long run, in contrast, exchange rate movements are driven by the "fundamentals," leading to a relationship between interest rates and exchange rates that is more consistent with UIP.