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Regime switches in exchange rate volatility and uncovered interest parity

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  • Ichiue, Hibiki
  • Koyama, Kentaro

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.

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  • Ichiue, Hibiki & Koyama, Kentaro, 2011. "Regime switches in exchange rate volatility and uncovered interest parity," Journal of International Money and Finance, Elsevier, vol. 30(7), pages 1436-1450.
    • Handle: RePEc:eee:jimfin:v:30:y:2011:i:7:p:1436-1450
    DOI: 10.1016/j.jimonfin.2011.07.003
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    More about this item

    Keywords

    Uncovered interest rate parity; Forward discount puzzle; Carry trade; Markov-switching model; Bayesian Gibbs sampling;
    All these keywords.

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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