Carry Trades and Exchange Rate Volatility: A TVAR Approach

47 Pages Posted: 2 Apr 2016 Last revised: 4 Apr 2016

See all articles by Alessio Anzuini

Alessio Anzuini

Bank of Italy

Francesca Brusa

Temple University - Fox School of Business

Date Written: January 21, 2016

Abstract

Recent empirical studies have established that deviations from the Uncovered Interest Parity (UIP) condition may be different across macroeconomic regimes. We extend this work to account for possible nonlinearities and endogeneity by estimating a Threshold Vector Autoregression (TVAR) model. Using carry trade proxies as in Brunnermeier et al. (2009) alongside a measure of realized exchange rate volatility, we endogenously identify two volatility regimes: low and high. Simulating an incentive to open a carry-trade position through an orthogonal shock to the interest rate differential, we find that carry trade performance varies across different regimes. This suggests that UIP deviations are more pronounced in the low volatility state and non-linearities play a role in explaining the forward bias.

Keywords: Threshold Vector Autoregression, carry trade

JEL Classification: C32, G15

Suggested Citation

Anzuini, Alessio and Brusa, Francesca, Carry Trades and Exchange Rate Volatility: A TVAR Approach (January 21, 2016). Bank of Italy Temi di Discussione (Working Paper) No. 1046, Available at SSRN: https://ssrn.com/abstract=2757086 or http://dx.doi.org/10.2139/ssrn.2757086

Alessio Anzuini (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

Francesca Brusa

Temple University - Fox School of Business ( email )

1801 Liacouras Walk
Alter Hall #426
Philadelphia, PA Pennsylvania 19122
United States
+12152046477 (Phone)

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