Do interest rate differentials drive the volatility of exchange rates? Evidence from an extended stochastic volatility model

We study the link between the volatility of exchange rates and interest rate differentials (IRD), motivated by the importance of currency carry trade activities in exchange rate dynamics. We examine this link by means of an extended stochastic volatility model, for which we detail an efficient estimation strategy based on Gaussian mixture sampling and a linearization of the volatility process. We apply this approach to six currency pairs over the period from January 1999 to December 2017. Our results suggest that changes in IRD affect volatility differently for low and high-interest-rate currencies. The volatility reacts strongly and positively to increases in the low interest rate, an effect consistent with the unwinding of carry trade positions. In contrast, the response to a raise in the high interest rate is negative and substantially smaller. In general, we find that the informational content of the interest rate differentials regarding the volatility of exchange rate is greater during and after the global financial crisis, compared to the pre-crisis period.