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Regime Switches in Exchange Rate Volatility and Uncovered Interest Parity

Author

Listed:
  • Hibiki Ichiue

    (Bank of Japan)

  • Kentaro Koyama

    (Bank of Japan)

Abstract

We use a regime-switching model to examine how exchange rate volatilities influence the failure of uncovered interest parity (UIP). Main findings are as follows. First, exchange rate returns are significantly influenced by regime switches in the relationship between the returns and interest rate differentials. Second, appreciation of low-yielding currencies occurs less frequently but is faster than the depreciation. Third, low volatilities and UIP failure are mutually dependent. Finally, these findings are more evident for three-month maturity than six-month maturity. These results are consistent with market participants' views: the short-term carry trade in a low-volatility environment and its rapid unwinding substantially influence exchange rates.

Suggested Citation

  • Hibiki Ichiue & Kentaro Koyama, 2007. "Regime Switches in Exchange Rate Volatility and Uncovered Interest Parity," Bank of Japan Working Paper Series 07-E-22, Bank of Japan.
    • Handle: RePEc:boj:bojwps:07-e-22
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    More about this item

    Keywords

    Uncovered interest rate parity; Forward discount puzzle; Carry trade; Markov-switching model; Bayesian Gibbs sampling;
    All these keywords.

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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