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When does uncovered interest parity hold?

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  • Moore, Michael J.
  • Roche, Maurice J.

Abstract

A consensus is emerging that returns to the currency carry trade are driven by two factors. One of these is probably consumption risk but there is widespread disagreement about the identity of the remaining factor. This paper bolsters the case for volatility being the unknown factor. A structural model that specifies that monetary volatility is the second factor is tested for 56 monetary regimes using the artificial economy methodology. The negative slope in the Fama regression arises when monetary volatility is low and the precautionary savings motive dominates the intertemporal substitution motive. When monetary volatility is high, the Fama slope is positive in line with uncovered interest parity. We conclude that, given the predominance of precautionary savings, the degree of monetary volatility explains whether uncovered interest parity holds.

Suggested Citation

  • Moore, Michael J. & Roche, Maurice J., 2012. "When does uncovered interest parity hold?," Journal of International Money and Finance, Elsevier, vol. 31(4), pages 865-879.
    • Handle: RePEc:eee:jimfin:v:31:y:2012:i:4:p:865-879
    DOI: 10.1016/j.jimonfin.2012.01.005
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    Cited by:

    1. Lothian, James R., 2016. "Uncovered interest parity: The long and the short of it," Journal of Empirical Finance, Elsevier, vol. 36(C), pages 1-7.
    2. Yamani, Ehab, 2019. "Diversification role of currency momentum for carry trade: Evidence from financial crises," Journal of Multinational Financial Management, Elsevier, vol. 49(C), pages 1-19.
    3. Straetmans, Stefan T.M. & Versteeg, Roald J. & Wolff, Christian C.P., 2013. "Are capital controls in the foreign exchange market effective?," Journal of International Money and Finance, Elsevier, vol. 35(C), pages 36-53.
    4. Ali Shehadeh & Peter Erdos & Youwei Li & Michael Moore, 2016. "US Dollar Carry Trades in the Era of "Cheap Money"," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 66(5), pages 374-404, October.
    5. Martin D. D. Evans, 2017. "Exchange-Rate Dark Matter," World Scientific Book Chapters, in: Studies in Foreign Exchange Economics, chapter 4, pages 101-185, World Scientific Publishing Co. Pte. Ltd..
    6. Demosthenes N. Tambakis & Nikola Tarashev, 2012. "Systematic monetary policy and the forward premium puzzle," BIS Working Papers 396, Bank for International Settlements.
    7. Bhatti, Razzaque H., 2014. "The existence of uncovered interest parity in the CIS countries," Economic Modelling, Elsevier, vol. 40(C), pages 227-241.
    8. Yamani, Ehab, 2021. "Foreign exchange market efficiency and the global financial crisis: Fundamental versus technical information," The Quarterly Review of Economics and Finance, Elsevier, vol. 79(C), pages 74-89.
    9. Chu, Shiou-Yen, 2015. "Funding liquidity constraints and the forward premium anomaly in a DSGE model," International Review of Economics & Finance, Elsevier, vol. 39(C), pages 76-89.
    10. Aysun, Uluc & Lee, Sanglim, 2014. "Can time-varying risk premiums explain the excess returns in the interest rate parity condition?," Emerging Markets Review, Elsevier, vol. 18(C), pages 78-100.
    11. Shehadeh, Ali A. & Li, Youwei & Vigne, Samuel A. & Almaharmeh, Mohammad I. & Wang, Yizhi, 2021. "The existence and severity of the forward premium puzzle during tranquil and turbulent periods: Developed versus developing country currencies," International Review of Financial Analysis, Elsevier, vol. 78(C).
    12. Vithessonthi, Chaiporn, 2014. "Monetary policy and the first- and second-moment exchange rate change during the global financial crisis: Evidence from Thailand," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 29(C), pages 170-194.
    13. Elias, Nikolaos & Smyrnakis, Dimitris & Tzavalis, Elias, 2024. "The forward premium anomaly and the currency carry trade hypothesis," The Quarterly Review of Economics and Finance, Elsevier, vol. 95(C), pages 203-218.
    14. Michael D. Goldberg & Olesia Kozlova & Deniz Ozabaci, 2020. "Forward Rate Bias in Developed and Developing Countries: More Risky Not Less Rational," Econometrics, MDPI, vol. 8(4), pages 1-26, December.
    15. Vithessonthi, Chaiporn, 2014. "What explains the initial return of initial public offerings after the 1997 Asian financial crisis? Evidence from Thailand," Journal of Multinational Financial Management, Elsevier, vol. 27(C), pages 89-113.
    16. Hayakawa, Kazunobu & Kim, Han-Sung & Yoshimi, Taiyo, 2017. "Exchange rate and utilization of free trade agreements: Focus on rules of origin," Journal of International Money and Finance, Elsevier, vol. 75(C), pages 93-108.
    17. Shehadeh, Ali & Li, Youwei & Moore, Michael, 2016. "The Forward Premium Bias, Carry Trade Return and the Risks of Volatility and Liquidity," MPRA Paper 71709, University Library of Munich, Germany.
    18. Brian Lucey & Grace Loring, 2012. "Forward Exchange Rate Biasedness across Developed and Developing Country Currencies - Do Observed Patterns Persist Out of Sample?Abstract:," The Institute for International Integration Studies Discussion Paper Series iiisdp404, IIIS.
    19. Kearney, Fearghal & Cummins, Mark & Murphy, Finbarr, 2019. "Using extracted forward rate term structure information to forecast foreign exchange rates," Journal of Empirical Finance, Elsevier, vol. 53(C), pages 1-14.
    20. Norman C. Miller, 2014. "Exchange Rate Economics," Books, Edward Elgar Publishing, number 14981.
    21. Auer, Benjamin R. & Hoffmann, Andreas, 2016. "Do carry trade returns show signs of long memory?," The Quarterly Review of Economics and Finance, Elsevier, vol. 61(C), pages 201-208.
    22. Kumar, Satish, 2019. "Does risk premium help uncover the uncovered interest parity failure?," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 63(C).
    23. Adewuyi, Adeolu O. & Ogebe, Joseph O., 2019. "The validity of uncovered interest parity: Evidence from african members and non-member of the organisation of petroleum exporting countries (OPEC)," Economic Modelling, Elsevier, vol. 82(C), pages 229-249.
    24. Mr. Martin D Evans, 2012. "Exchange-Rate Dark Matter," IMF Working Papers 2012/066, International Monetary Fund.

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    More about this item

    Keywords

    Monetary volatility; Uncovered interest parity; Forward bias puzzle; Habit persistence; Carry trade;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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