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

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  • Matthew Ames
  • Guillaume Bagnarosa
  • Gareth W. Peters

Abstract

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.

Suggested Citation

  • Matthew Ames & Guillaume Bagnarosa & Gareth W. Peters, 2013. "Reinvestigating the Uncovered Interest Rate Parity Puzzle via Analysis of Multivariate Tail Dependence in Currency Carry Trades," Papers 1303.4314, arXiv.org, revised Jan 2014.
  • Handle: RePEc:arx:papers:1303.4314
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    References listed on IDEAS

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    1. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 2011. "Common Risk Factors in Currency Markets," Review of Financial Studies, Society for Financial Studies, vol. 24(11), pages 3731-3777.
    2. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2008. "Arbitrage in the foreign exchange market: Turning on the microscope," Journal of International Economics, Elsevier, vol. 76(2), pages 237-253, December.
    3. Hanno Lustig & Adrien Verdelhan, 2007. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk," American Economic Review, American Economic Association, vol. 97(1), pages 89-117, March.
    4. Emmanuel Farhi & Xavier Gabaix, "undated". "Rare Disasters and Exchange Rates," Working Paper 71001, Harvard University OpenScholar.
    5. Lukas Menkhoff & Lucio Sarno & Maik Schmeling & Andreas Schrimpf, 2012. "Carry Trades and Global Foreign Exchange Volatility," Journal of Finance, American Finance Association, vol. 67(2), pages 681-718, April.
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