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Carry trades and endogenous regime switches in exchange rate volatility

Author

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  • Cho, Dooyeon
  • Han, Heejoon
  • Lee, Na Kyeong

Abstract

This paper investigates the profitability of carry trades by taking into account the endogeneity of regime switching between low and high states of exchange rate volatility. The analysis uses an endogenous regime switching model with an autoregressive latent factor, in which the future transition between states depends on the current state as well as the realization of the underlying time series. The results show that carry trades are profitable in a regime with low exchange rate volatility, signifying the failure of uncovered interest rate parity (UIP). However, carry trades yield losses in a regime with high exchange rate volatility, which implies a reversion to UIP. The endogenous latent factor obtained from the model represents historical economic downturns associated with carry trade losses well. It also appears to exhibit a similar pattern to those of two measures of uncertainty, macroeconomic uncertainty and economic policy uncertainty.

Suggested Citation

  • Cho, Dooyeon & Han, Heejoon & Lee, Na Kyeong, 2019. "Carry trades and endogenous regime switches in exchange rate volatility," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 58(C), pages 255-268.
  • Handle: RePEc:eee:intfin:v:58:y:2019:i:c:p:255-268
    DOI: 10.1016/j.intfin.2018.11.001
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    References listed on IDEAS

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    Cited by:

    1. Sensoy, Ahmet & Serdengeçti, Süleyman, 2020. "Impact of portfolio flows and heterogeneous expectations on FX jumps: Evidence from an emerging market," International Review of Financial Analysis, Elsevier, vol. 68(C).
    2. Qian Zhang & Kuo-Jui Wu & Ming-Lang Tseng, 2019. "Exploring Carry Trade and Exchange Rate toward Sustainable Financial Resources: An application of the Artificial Intelligence UKF Method," Sustainability, MDPI, Open Access Journal, vol. 11(12), pages 1-1, June.
    3. Li, XiaoPing & Tong, Bin & Zhou, ChunYang, 2020. "Uncertainty aversion, carry trades and agent heterogeneity in the FX market," Finance Research Letters, Elsevier, vol. 36(C).

    More about this item

    Keywords

    Endogenous regime switching model; Carry trades; Exchange rate volatility; Latent factor; Uncovered interest rate parity;

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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