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Carry Trade, Uncovered Interest Parity and Monetary Policy

Author

Listed:
  • Dániel Felcser

    (Magyar Nemzeti Bank (the central bank of Hungary))

  • Balázs Vonnák

    (Magyar Nemzeti Bank (the central bank of Hungary))

Abstract

It is well documented in the literature that identified vector autoregression (VAR) models often produce puzzling results when the effect of unexpected monetary policy movements is estimated. Many authors find that raising interest rate generates protracted appreciation of the exchange rate (the so-called delayed overshooting puzzle) which is in contradiction with traditional theory of exchange rate dynamics based on uncovered interest parity. Since the dynamics of exchange rate is determined to a substantial extent by carry traders, we investigate the behaviour of the exchange rate and carry trade activity within the same VAR for a panel of small open economies. We identify structural shocks by allowing the interest rate and exchange rate to react simultaneously to monetary policy and changes in expected risk premium. Our results show that the delayed overshooting is not a robust finding. Exchange rate appreciation and carry trade movements take place almost on impact after an unexpected interest rate hike. Roughly half of the variation in carry trade positions can be explained by domestic interest rate changes and risk premium shocks.

Suggested Citation

  • Dániel Felcser & Balázs Vonnák, 2014. "Carry Trade, Uncovered Interest Parity and Monetary Policy," MNB Working Papers 2014/3, Magyar Nemzeti Bank (Central Bank of Hungary).
    • Handle: RePEc:mnb:wpaper:2014/3
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    Citations

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    Cited by:

    1. Cyril Dell'Eva & Eric Girardin & Patrick A. Pintus, 2020. "Monetary Policies and Destabilizing Carry Trades under Adaptive Learning," Working Papers halshs-02872378, HAL.
    2. repec:beo:journl:v:62:y:2018:i:216:p:35-62 is not listed on IDEAS
    3. Zorica Mladenović & Jelena Rašković, 2018. "Econometric Testing Of Uncovered Interest Rate Parity In Serbia," Economic Annals, Faculty of Economics and Business, University of Belgrade, vol. 63(216), pages 35-62, January –.
    4. Georgiadis, Georgios & Jančoková, Martina, 2020. "Financial globalisation, monetary policy spillovers and macro-modelling: Tales from 1001 shocks," Journal of Economic Dynamics and Control, Elsevier, vol. 121(C).
    5. Juan Carlos Cuestas & Fabio Filipozzi & Karsten Staehr, 2017. "Uncovered interest parity in Central and Eastern Europe: Expectations and structural breaks," Review of International Economics, Wiley Blackwell, vol. 25(4), pages 695-710, September.
    6. Juan Carlos Cuestas & Fabio Filipozzi & Karsten Staehr, 2015. "Uncovered Interest Parity in Central and Eastern Europe: Sample, Expectations and Structural Breaks," Working Papers 2015014, The University of Sheffield, Department of Economics.

    More about this item

    Keywords

    delayed overshooting; vector autoregressions; carry trade; monetary policy;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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