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Reinvestigating the Uncovered Interest Rate Parity Puzzle via Analysis of Multivariate Tail Dependence in Currency Carry Trades

  • Matthew Ames
  • Guillaume Bagnarosa
  • Gareth W. Peters
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    The currency carry trade is the investment strategy that involves selling low interest rate currencies in order to purchase higher interest rate currencies, thus profiting from the interest rate differentials. This is a well known financial puzzle to explain, since assuming foreign exchange risk is uninhibited and the markets have rational risk-neutral investors, then one would not expect profits from such strategies. That is uncovered interest rate parity (UIP), the parity condition in which exposure to foreign exchange risk, with unanticipated changes in exchange rates, should result in an outcome that changes in the exchange rate should offset the potential to profit from such interest rate differentials. The two primary assumptions required for interest rate parity are related to capital mobility and perfect substitutability of domestic and foreign assets. Given foreign exchange market equilibrium, the interest rate parity condition implies that the expected return on domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets. However, it has been shown empirically, that investors can actually earn arbitrage profits by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, whilst allowing for any losses (or gains) from exchanging back to their domestic currency at maturity. Therefore trading strategies that aim to exploit the interest rate differentials can be profitable on average. The intention of this paper is therefore to reinterpret the currency carry trade puzzle in light of heavy tailed marginal models coupled with multivariate tail dependence features in the analysis of the risk-reward for the currency portfolios with high interest rate differentials and low interest rate differentials.

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    Paper provided by in its series Papers with number 1303.4314.

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    Date of creation: Mar 2013
    Date of revision: Jan 2014
    Handle: RePEc:arx:papers:1303.4314
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    1. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 0. "Common Risk Factors in Currency Markets," Review of Financial Studies, Society for Financial Studies, vol. 24(11), pages 3731-3777.
    2. Menkhoff, Lukas & Sarno, Lucio & Schmeling, Maik & Schrimpf, Andreas, 2011. "Carry Trades and Global Foreign Exchange Volatility," CEPR Discussion Papers 8291, C.E.P.R. Discussion Papers.
    3. Emmanuel Farhi & Xavier Gabaix, . "Rare Disasters and Exchange Rates," Working Paper 71001, Harvard University OpenScholar.
    4. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2006. "Arbitrage in the Foreign Exchange Market: Turning on the Microscope," SIFR Research Report Series 42, Institute for Financial Research.
    5. Hanno Lustig & Adrien Verdelhan, 2006. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk," Boston University - Department of Economics - Working Papers Series WP2006-045, Boston University - Department of Economics.
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