The Carry Trade and Uncovered Interest Parity When Markets Are Incomplete

60 Pages Posted: 23 May 2015 Last revised: 29 May 2015

See all articles by Jack Y Favilukis

Jack Y Favilukis

University of British Columbia (UBC) - Division of Finance

Lorenzo Garlappi

University of British Columbia (UBC) - Sauder School of Business

Sajjad Neamati

University of British Columbia (UBC) - Division of Finance

Date Written: May 5, 2015

Abstract

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.

Keywords: uncovered interest parity, carry trade, incomplete markets, non-traded goods, Backus-Smith puzzle, Balassa-Samuelson effect, sovereign default

JEL Classification: F31; F41; G15

Suggested Citation

Favilukis, Jack Y and Garlappi, Lorenzo and Neamati, Sajjad, The Carry Trade and Uncovered Interest Parity When Markets Are Incomplete (May 5, 2015). Available at SSRN: https://ssrn.com/abstract=2609151 or http://dx.doi.org/10.2139/ssrn.2609151

Jack Y Favilukis

University of British Columbia (UBC) - Division of Finance ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Lorenzo Garlappi (Contact Author)

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Sajjad Neamati

University of British Columbia (UBC) - Division of Finance ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

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