Bond Convenience Yields and Exchange Rate Dynamics

92 Pages Posted: 27 Mar 2016 Last revised: 8 Jul 2017

Date Written: July 7, 2017

Abstract

I propose a new explanation for the failure of Uncovered Interest Parity (UIP) that can rationalize not only the classic UIP puzzle, but also the evidence that the puzzle reverses direction at longer horizons. In the model, excess currency returns arise as compensation for endogenous fluctuations in bond convenience yield differentials. Due to the interaction of monetary and fiscal policy, the dynamics of the equilibrium convenience yield are non-monotonic, which generates the reversal of the puzzle. I also show that the relationship between UIP violations and monetary and fiscal policy, and government debt is also borne out by the data.

Keywords: Uncovered Interest Rate Parity, Exchange Rates, Open Economy Macroeconomics, Bond Convenience Yield, Monetary-Fiscal Interaction, Government Debt Dynamics

JEL Classification: F31, F41, F42, E43, E52, E63

Suggested Citation

Valchev, Rosen, Bond Convenience Yields and Exchange Rate Dynamics (July 7, 2017). Sloan Foundation Economics Research Paper Forthcoming, Available at SSRN: https://ssrn.com/abstract=2755048 or http://dx.doi.org/10.2139/ssrn.2755048

Rosen Valchev (Contact Author)

Boston College ( email )

140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States

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