Regime switches in exchange rate volatility and uncovered interest parity

• Published in: Journal of international money and finance Vol. 30; no. 7; pp. 1436 - 1450
• Main Authors: Ichiue, Hibiki, Koyama, Kentaro
• Format: Journal Article
• Language: English
• Published: Kidlington Elsevier Ltd 01-11-2011; Elsevier Science Ltd
• Subjects: Bayesian Gibbs sampling; Carry trade; Currencies; Economic models; Economic theory; Exchange rates; Foreign exchange rates; Forward discount puzzle; Fund management; Interest rate parity theorem; Interest rates; Liquidity; Markov-switching model; Studies; Uncovered interest rate parity; Volatility; G15; Forward discount puzzle; Uncovered interest rate parity; Carry trade; Bayesian Gibbs sampling; Markov-switching model
• ISSN: 0261-5606; 1873-0639
• DOI: 10.1016/j.jimonfin.2011.07.003

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.