Reinvestigating the Uncovered Interest Rate Parity Puzzle via Analysis of Multivariate Tail Dependence in Currency Carry Trades

26 Pages Posted: 22 Mar 2013 Last revised: 23 Jan 2014

See all articles by Matthew Ames

Matthew Ames

ResilientML; The Institute of Statistical Mathematics

Guillaume Bagnarosa

ESC Rennes School of Business

Gareth Peters

University of California Santa Barbara; University of California, Santa Barbara

Date Written: December 15, 2013

Abstract

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.

Keywords: Currency carry trade, Multivariate tail dependence, Forward premium puzzle, Mixture copula models, Generalized Archimedean copula, Extreme value copula

JEL Classification: G12, G14, C58, C32

Suggested Citation

Ames, Matthew and Ames, Matthew and Bagnarosa, Guillaume and Peters, Gareth, Reinvestigating the Uncovered Interest Rate Parity Puzzle via Analysis of Multivariate Tail Dependence in Currency Carry Trades (December 15, 2013). Available at SSRN: https://ssrn.com/abstract=2235687 or http://dx.doi.org/10.2139/ssrn.2235687

Matthew Ames (Contact Author)

ResilientML ( email )

Melbourne
Australia

The Institute of Statistical Mathematics ( email )

Tokyo
Japan

Guillaume Bagnarosa

ESC Rennes School of Business ( email )

2, RUE ROBERT D'ARBRISSEL
Rennes, 35065
France

Gareth Peters

University of California Santa Barbara ( email )

Santa Barbara, CA 93106
United States

University of California, Santa Barbara ( email )

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
223
Abstract Views
1,455
Rank
210,562
PlumX Metrics