Abstract
We use a regime-switching model to examine how exchange rate volatility is related to the failure of uncovered interest parity. Main findings are as follows. First, exchange rate returns are strongly influenced by regime switches in the relationship between the returns and interest rate differentials. Second, low-yielding currencies appreciate less frequently, but once it occurs, their movements are faster than when they depreciate. Third, depreciation of low-yielding currencies and low volatility are mutually dependent on each other. Finally, these three findings are more evident for shorter horizons. The second and third results are consistent with a market participants' view: short-term carry trades in a low-volatility environment and their rapid unwinding substantially influence exchange rates. We consider the effects of funding liquidity to explain these results.
Original language | English |
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Pages (from-to) | 1436-1450 |
Number of pages | 15 |
Journal | Journal of International Money and Finance |
Volume | 30 |
Issue number | 7 |
DOIs | |
Publication status | Published - 2011 Nov |
Externally published | Yes |
Keywords
- Bayesian Gibbs sampling
- Carry trade
- Forward discount puzzle
- Markov-switching model
- Uncovered interest rate parity
ASJC Scopus subject areas
- Finance
- Economics and Econometrics