Perspectives on Uncovered Interest Rate Parity and the Carry Trade: Some Recent Evidence for G10 and Emerging Markets

Abstract

Uncovered interest rate parity (UIRP) indicates that international yield differentials reflect expected depreciation of the high-yield currency. However high-yield currencies tend to appreciate, at least in the short run, which implies predictable currency excess returns and trading profitability. The carry trade, buying high-interest currencies and selling low-interest ones, is a direct corollary of the failure of UIRP. Recent academic literature shows that protracted UIRP violations are not a statistical artifact and that the carry trade is profitable on average but subject to large infrequent losses so that explanations of UIRP failures have to be analytical but they remain elusive. Currency asset managers and hedge funds have been profitably using variations of the carry trade for a long time and are trying to develop models with conditioning variables to anticipate draw downs or reduce their severity. Central banks of small open economies use either interest rate rules or foreign exchange (FX) rate rules that assume UIRP holds. Whether this assumption is detrimental for policy making is an open issue. I selectively review some literature and discuss recent lines of interaction between academic and practitioner research. I use recent data for G10 and Emerging Market currencies (including several Latin American countries) to revisit individual and panel regression tests of UIRP, the econometric issues around them, and how they connect with carry trade performance. I illustrate how economic models of FX may provide a long-run anchor such that large deviations from equilibrium eventually get corrected. This would not explain why UIRP deviations exist but rather why they get reversed. Despite the apparent irrelevance of stand-alone economic models to predict future FX, using them to adjust rate differentials drastically reduces losses of carry trades so it seems a very promising line of research on FX turning points. The updated evidence has value to better understand FX markets and to improve currency management for institutional investors and central banks.