Uncovered Interest Parity And Carry Trades

Master's Thesis from the year 2016 in the subject Business economics - Banking, Stock Exchanges, Insurance, Accounting, grade: 1,0, University of Frankfurt (Main) (Goethe Business School), language: English, abstract: The aim of this thesis is to test UIP by implementing an OLS regression analysis for five currency pairs which, according to CFTC data, global turnover data and carry-to-risk ratios, were among the most popular in the investor community. To increase the significance of this thesis for practitioners, the work will use one-month forward contracts which are used frequently by investors and include bid and ask rates in order to account for transaction costs. In addition, all currency pairs include the US Dollar for reasons of better liquidity, and therefore tighter bid-ask spreads. Moreover, this thesis will present recent findings in literature which try to explain deviations from UIP. Approaches can be separated by the focus on a risk premium, by irrational market behavior or by learning problems and market inefficiency. While most focus is laid on an explanation by a risk premium, it will be shown that it is crucial to combine the different scientific disciplines in order to solve the forward premium puzzle. In addition to this, the thesis will provide an outlook on the future attractiveness of carry trade strategies.

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.

Many of the leading models of the carry trade imply that, contrary to the empirical evidence, a country's currency depreciates in times of high consumption and output growth, a manifestation of the Backus and Smith (1993) puzzle. We propose a modification of these models to account for financial market incompleteness and show that such a modification can induce positive correlation between currency appreciation and consumption or output growth while, at the same time, helping resolve the Backus and Smith (1993) and Brandt, Cochrane and SantaClara (2006) puzzles. Furthermore, in many of the existing models, the assumed fundamental cross-country differences (output volatility, growth, and risk attitude) responsible for interest rate differentials also appear at odds with the data. We document that default risk and financial openness are strongly related to interest rate differentials and carry trade profits in the data. The incomplete markets model we propose is consistent with these novel empirical facts.

For about three decades until the Global Financial Crisis (GFC), Covered Interest Parity (CIP) appeared to hold quite closely—even as a broad macroeconomic relationship applying to daily or weekly data. Not only have CIP deviations significantly increased since the GFC, but potential macrofinancial drivers of the variation in CIP deviations have also become significant. The variation in CIP deviations seems to be associated with multiple factors, not only regulatory changes. Most of these do not display a uniform importance across currency pairs and time, and some are associated with possible temporary considerations (such as asynchronous monetary policy cycles).

The Uncovered Interest Parity (UIP) puzzle has remained a moot point since it first circulated economic discourse in 1984 and, despite a number of attempts at a solution, the UIP puzzle and other anomalies in Exchange Rate Economics continue to perplex

The incredible profitability of the carry trade over the past six decades constitutes a puzzle for interest rate parity. Contrary to recent behavioral or friction based approaches that explain deviations from traditional interest rate parity, I examine the effect of foreign sovereign credit risk and associated sharp currency devaluations on interest rate parity. To ensure that the theoretical implications apply generally, the setting is a continuous time arbitrage pricing model driven by Levy processes. I derive the statements of covered and uncovered interest rate parity under credit risk. The model produces novel measures of sovereign credit risk and carry trade profitability - most notably, forward-implied default intensities and the difference of same-maturity futures and forward prices. Empirically, introducing credit risk into the statement of covered interest rate parity makes pricing errors vanish for Mexico and the G10 countries: The profitability of both the covered and uncovered carry trade are fully accounted for by a modest allowance for credit risk and currency devaluation. I find mixed results for a carry trade trading system whose long/short position is determined by an estimate of the risk neutral expected return to the carry trade.

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