Violations of Uncovered Interest Rate Parity and International Exchange Rate Dependences

34 Pages Posted: 1 Aug 2015

See all articles by Matthew Ames

Matthew Ames

The Institute of Statistical Mathematics

Guillaume Bagnarosa

ESC Rennes School of Business

Gareth Peters

Department of Actuarial Mathematics and Statistics, Heriot-Watt University; University College London - Department of Statistical Science; University of Oxford - Oxford-Man Institute of Quantitative Finance; London School of Economics & Political Science (LSE) - Systemic Risk Centre; University of New South Wales (UNSW) - Faculty of Science

Date Written: July 23, 2015

Abstract

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

Keywords: Forward Premium Puzzle, Speculative Trading Volumes, Multivariate Tail Dependence, Mixture Copula Models, Currency Carry Trade, Covariance Regressions

JEL Classification: G12, G14, C58, C32, E5, F31

Suggested Citation

Ames, Matthew and Bagnarosa, Guillaume and Peters, Gareth, Violations of Uncovered Interest Rate Parity and International Exchange Rate Dependences (July 23, 2015). Available at SSRN: https://ssrn.com/abstract=2638163 or http://dx.doi.org/10.2139/ssrn.2638163

Matthew Ames (Contact Author)

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

Department of Actuarial Mathematics and Statistics, Heriot-Watt University ( email )

Edinburgh Campus
Edinburgh, EH14 4AS
United Kingdom

HOME PAGE: http://garethpeters78.wixsite.com/garethwpeters

University College London - Department of Statistical Science ( email )

1-19 Torrington Place
London, WC1 7HB
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

University of Oxford Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

London School of Economics & Political Science (LSE) - Systemic Risk Centre ( email )

Houghton St
London
United Kingdom

University of New South Wales (UNSW) - Faculty of Science ( email )

Australia

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