Interest Rate Differentials Research Articles

Volatility transmitter or receiver? Investigating dynamic connectedness between the carry trade and financial markets

By examining the connectedness of carry trade currency with stock, foreign exchange (forex), and commodity markets, the paper investigates the extent to which shocks in capital flows driven by interest-rate differentials affect financial markets. Following the framework of Diebold and Yilmaz (2012), we find that dynamic spillovers alternate between positive and negative, but, during the Covid-19 pandemic, the carry trade is the main net transmitter of volatility to all markets. Our findings confirm the ability of carry trade to increase financial vulnerability and amplify market turbulence, especially in the forex market.

Mexico: Determinants of the real exchange rate, 2001.01-2022.12.

We estimate the determinants (terms of trade, tradable to non-tradable price differentials, interest rate differentials, forward exchange rate and risk premium) of the Mexican bilateral real exchange rate (q) for the short and long run by using an Autoregressive Distributed Lag model (ARDL, Pesaran and Shin et al. (2001)) for Mexico (2001.01-2022.12). The inclusion of commercial and financial variables and finding empirical evidence of cointegration only for 2009.01-2022.12 are the main contributions. Our results indicate no cointegrating relationship either for the entire sample, or for 2001.01-2008.12. This finding has to do with the increasing international financialization process, after the 2008-2009 Great Financial Crisis. Using a double log model we find that: a) there is a strong short-run autoregressive effect of q of up to 4 lags (0.75), b) that the Balassa-Samuelson Effect is the largest in the model (-0.27 and -1.11 for short and long terms), c) the next most important factor is the terms of trade (-0.126 and -0.51, respectively), d) there are considerable, although lesser, effects of financial variables: forward exchange rate (0.0155 and 0.063, respectively) and risk-premium (0.009 and 0.036, respectively), e) there is a clear long-term trend of real depreciation expressed by the trend of 0.0020, which suggests that the PPP hypothesis applies.

Do exchange rate and inflation matters to Nigerian economy?New evidence from vector autoregressive (VAR) approach

Currency fluctuations and inflation are the natural norm for most major economies. Numerous factors influenceeconomic growth, including a country’s exchange rate system performance, the outlook for inflation, and interestrate differentials. These are the most significant factors that hinder the economic growth of every nation. As aresult, this analysis investigates the impact of exchange rate and inflation on Nigeria’s growth performance from1986 to 2021. Impulse response and variance decomposition were estimated. The real gross domestic product(RGDP) was used as a proxy for growth performance, while the inflation rate (IFNR), real exchange rate (REXR),and interest rate (INTR) were also used as proxies. The results of impulse response and variance decompositionestimates in the short-run (third quarter) and long-run (tenth quarter) show that real exchange rate D(REXR), INTR,and IFNR all have a positive impact on RGDP variation, with values of 13.38, 31.88, and 22.40%, respectively,in the third quarter. In the long run (the 10th quarter), REXR contributed approximately 28.76% of the variationin RGDP. The interest rate contributed 24.14%, while the IFNR has contributed about 28.27% of the variation inRGDP in the long run. Therefore, summing the contributions of REXR, INTR, and INFR to RGDP, these variablescontributed about 81.17% of the variation in RGDP in the long run. Hence, the research concluded that REXR,INTR, and IFNR have a positive effect on growth performance as proxied by RGDP in Nigeria within the periodof the research. The research recommended that the government should provide a policy that will reduce theexcess growth of aggregate demand (AD) in the economy, which will reduce inflationary pressure, in order toachieve the sustainable development goals (SDGs) of 2030 in Nigeria, which include restoring economic growthand macroeconomic stability through macroeconomic variables such as the exchange rate, inflation, and othersignificant variables.

Sector Specific Determinants of Foreign Portfolio Investment Inflows in India: A Panel ARDL Approach

This article investigates the factors that influence foreign portfolio investment (FPI) inflows to various sectors in India from February 2012 to July 2020. We find evidence that in the short-run FPI inflows in India have a significant positive relationship with the index of industrial production (IIP), foreign direct investment (FDI) and market capitalization (MC) while a significant negative relationship with the US dollars exchange rate (DEXR) and real effective exchange rate (REER). The results of the panel autoregressive distributed lag (ARDL) approach show that sectoral FPI inflows to the various sector in India have a significant negative relationship with interest rate differential (IRD), MC and the US DEXR in the long run. However, in the long run, it has a significant positive relationship with international liquidity (IL) and REER. In addition, we observe that for all sectors the interest rate differential boosts FPI inflows in India except for new economy sectors. The policy prescription of the study points toward the creation of a conducive investment climate to encourage foreign portfolio investors.

A comparative study of bank efficiency in three Chinese regions: Mainland China, Hong Kong, and Macao

AbstractWe conduct a bank efficiency comparison among three Chinese regions: Mainland China (CN), Hong Kong (HK), and Macao (MO). Specifically, we investigate the reasons for efficiency differences observed in the three regions from within‐region and cross‐region perspectives. We show that HK and MO maintain stable bank performance over time that lies within the developed‐economy range of efficiency levels. CN used to be well below this range but has been catching up so quickly that efficiency convergence in the three regions seems to be underway. We find that the determinants of bank efficiencies in the three Chinese jurisdictions are similar in some aspects but different in others. Most significant are their similarities in the effects of interest rate differentials, forex reserve accumulations, bank capital positions, interbank financing opportunities, and liquidity mismatch problems. Also important are their differences in the effects of bank size, revenue diversification, government ownership, property, and stock market development.

The Analysis of the Short-term Capital Movements by Using the VAR Model: The Case of Turkey

This paper investigates the relations among short-term capital inflows, government deficit, interest rate differentials, real exchange rate and some accounts of the balance of payments in Turkey in 1990s by using the vector autoregression (VAR) technique. The dynamic behaviours of each variable due to random shocks given to short-term foreign liabilities are captured by impulse response functions, and the portion of variance in the prediction for each variable in the system that is attributable to its own innovations and to shocks to other variables in the system is analysed by variance decomposition method. It is found that the policy of high interest-low exchange rate (hot money) is the main reason for the short-term capital inflows in Turkey, and we propose some main controls on capital inflows to limit some of the macroeconomic repercussions of these inflows.

The Long-run Relationship between Real Exchange Rate and Real Interest Rate in Asian Countries: An Application of Panel Cointegration

The role of exchange rate policy in economic development has been the subject of much debate and controversy in the development literature. Interest rates and exchange rates are usually viewed as important in the transmission of monetary impulses to the real economy. In the short run the standard view of academics and policy-makers is that a monetary expansion lowers the interest rate and rises the exchange rate, with these price changes then affecting the level and composition of aggregate demand. Frequently, these influences are described as the liquidity effects of monetary expansion, viewed as the joint effect of providing larger quantities of money to the private sector. Popular theories of exchange-rate determination also predict a link between real exchange rates and real interest rate differentials. These theories combine the uncovered interest parity relationship with the assumption that the real exchange rate deviates from its long-run level only temporarily. Under these assumptions, shocks to the real exchange rate—which are often viewed as caused by shocks to monetary policy—are expected to reverse themselves over time. This study investigates the long-run relationship between real exchange rates and real interest rate differentials using recently developed panel cointegration technique. Although this kind of relationship has been studied by a number of researchers,1 very little evidence in support of the relationship has been reported in the case of developing countries. For example, Meese and Rogoff (1988) and Edison and Pauls (1993), among others, used the Engle-Granger cointegration method and fail to establish a clear long-run relationship in their analysis.

The determinants of cross-border bond risk premia

Although cross-border bond issuance by emerging market economies (EMEs) has surged and dominated financing since the financial crisis of 2008, the sources of variation in cross-border bond risk premia have been ignored. This study fills this gap in the literature by examining the dynamic impact of interest rate differentials, exchange rates, and the broad dollar index on cross-border bond risk premia by applying a time-varying parameter vector autoregression (TVP-VAR) model with stochastic volatility. Generally, the risk premia responses are time-varying, lagged, and heterogeneous, with a reduction as the lag time horizon expands and the most significant in major global events. The empirical findings highlight that the broad dollar index dominates in explaining the variation of cross-border bond risk premia rather than the other two potential factors; we call this the “cross-border bond risk premia puzzle.” Furthermore, we find that the broad dollar index positively impacts cross-border bond risk premia via two transmission channels: 1) exchange rate expectations, which are significantly negatively driven by the broad dollar index, and 2) risk sentiment, which is negatively reflected by the index itself; both effects are negative. Moreover, the effect of the broad dollar index on risk premia is more pronounced for high-yield bonds than for investment-grade bonds. High-yield bond risk premia are negatively driven by exchange rate expectations, while investment-grade bond risk premia are positively driven by the local currency spread. Finally, these findings provide fresh insights into the aforementioned relationships; thus, we outline the implications.

Determinants of Foreign Exchange Rate of Selected Developing Countries: A Conceptual Review

Foreign exchange rate is often seen as an important factor that influences country’s level of productivity, employment rate as well as international trade. Therefore, constant fluctuation in currencies exchange rate has been a major concern in international business operation across countries of the world. This study focused on reviewing the determinants of foreign exchange rate from studies conducted in some developing countries of the world based on literature mapping approach between 1994 to 2020. The study concludes that trade, money supply, trade openness, domestic investment, interest rate differentials, foreign exchange, productivity, inflation, capital inflow, gross domestic production, current account balance, external debt, government spending, oil revenue, nominal exchange rate, price of gold, tariffs, investments, central bank intervention, foreign asset and net export were considered as determinants of foreign exchange rate in some the developing countries of the world.

Testing for the uncovered interest parity condition in a small open economy: A state space modelling approach

Do interest rate differentials smoothly mirror the changes in the exchange rate between a small open economy and a large emerging market economy? The literature provides conflicting views on the validity of the uncovered interest parity condition (UIP), including its size and factors influencing the risk premium. We examine the validity of the UIP condition between Nepal and India using time-series data covering the period 1989 – 2019. A state space modelling approach based on the Kalman filter analysis is applied to simulate the risk premium. We find that the UIP condition does not hold for the Nepalese Rupee. A time-varying persistent negative risk premium that dominantly explains interest rate differentials is, instead, found. These findings imply that Nepalese residents prefer to hold foreign assets and continually expect future devaluations of the domestic currency. These present obstacles to developing domestic financial markets and the implementation of a market oriented monetary policy.

External Commercial Borrowings by Indian Firms: A Blessing or Curse

In the first half of FY19, ECBs touched a high of $25.17 billion in the April – September period, which was 53 per cent higher than the $16.48 billion raised by Indian entities in the same period last year; it was $42 billion for FY19. Taking Reliance Industries Limited (RIL) as a case point, the researchers analysed the advantages of borrowing by a firm through an ECB and its impact on the company's net profit and shareholder's returns vis-à-vis borrowing the same money through a premium domestic public sector bank. The analysis of the loan of $300 million (`13.8 billion) taken as an ECB against being borrowed domestically through a strong public sector bank showed that it was beneficial for the firm to borrow due to differential interest rates through an ECB. Thus, the rationale that interest rate differential between rates charged for ECB and borrowing within the domestic boundaries of a county influences ECBs and that firms should hedge a minimum specified percentage of their currency exposure while borrowing through ECBs holds true.

Asymmetric impact of Sino-US interest rate differentials and economic policy uncertainty ratio on RMB exchange rate

• RMB exchange rate appreciation by widening Sino-US interest rate differentials is greater than depreciation by narrowing interest rate differentials. • RMB exchange rate responds more intensely to the increase than decrease in EPU ratio. • After the 2008 international financial crisis, the impact of Sino-US interest rate differentials and EPU ratio on the RMB exchange rate was weakened and reinforced, respectively. • COVID-19 has simultaneously intensified the responses of the RMB exchange rate to Sino-US interest rate differentials and EPU ratio. By using the NARDL model, we investigate the asymmetric relationship between Sino-US interest rate differentials, economic policy uncertainty (EPU) ratio, and the RMB exchange rate both in the long and short run. We further explore the changes in the asymmetric relations in light of the shocks of the 2008 international financial crisis and the COVID-19 pandemic. Our empirical results show that the long-run asymmetric effects of Sino-US interest rate differentials and EPU ratio on the RMB exchange rate are significant. Specifically, the RMB exchange rate appreciation resulting from the widening Sino-US interest rate differentials is greater than its depreciation resulting from the narrowing interest rate differentials in the long run. And the RMB exchange rate responds more intensely to the increase of Sino-US EPU ratio in the long run. In addition, in the aftermath of the 2008 international financial crisis, the impact of Sino-US interest rate differentials on the RMB exchange rate is found to be weaker, while the impact of the Sino-US EPU ratio on the RMB exchange rate is reinforced. COVID-19, for its part, has simultaneously intensified the responses of the RMB exchange rate to Sino-US interest rate differentials and EPU ratio.

Predicting Exchange Rate under UIRP Framework with Support Vector Regression

This study aimed to forecast the exchange rate between the Vietnamese dong and the US dollar for the following month in the context of the COVID-19 pandemic. It used the Support Vector Regression (SVR) algorithm under the Uncovered Interest Rate Parity (UIRP) theoretical framework; the results are compared with the Ordinary Least Square (OLS) regression model and the Random Walk (RW) model under the rolling window method. The data included the VND/USD exchange rate, the bank interest rate for the 1-month term, and the 1-month T-bill from January 01, 2020, to September 11, 2021. The research discovered a linear link between the two nations' exchange rates and interest rate differentials. Interest rate differentials are input variables to forecast interest rate differentials. Furthermore, the connection between the exchange rate and interest rate differentials during this era does not support the UIRP hypothesis; hence, the error for OLS predictions remains large. The study provided a model to forecast future exchange rates by combining the UIRP theoretical framework and the SVR algorithm. The UIRP theoretical framework can anticipate exchange rate differentials using the input variable and the interest rates between two nations. Meanwhile, the SVR algorithm is a robust machine learning technique that enhances prediction accuracy. Doi: 10.28991/ESJ-2022-06-03-014 Full Text: PDF

Effects of financial globalisation on interest rate differentials in India

India initiated a number of reforms in 1991, after opening up of the economy to the Global world. India’s integration with the global economy increased trade and accelerated economic growth. The outcome of the process of Globalisation and integration of the Indian economy has also led to integration of India’s financial market with the rest of the world. As an outcome of this process, there has been an excessive Capital inflow to the Indian economy exerting pressure on the asset prices. The purpose of this paper is to explain the impact of financial sector reform on Interest rate differentials in India. This study tries to focus on the sensitivity of interest rate differentials as a consequence of changes in the global economy, and its effects on the people. Though at the aggregate level, the inflow of Capital has created surge in economic activities and increased demand and supply, but the question of interest remains whether certain sections of the population have been overlooked. It has however been found that difference in deposit rates and various lending rates became wider because of financial integration. To sustain growth, micro economic issues needs better attention along with macro-economic targets.

A Theory-Consistent CVAR Scenario for a Monetary Model with Forward-Looking Expectations

A theory-consistent CVAR scenario describes a set of testable regularities capturing basic assumptions of the theoretical model. Using this concept, the paper considers a standard model for exchange rate determination with forward-looking expectations and shows that all assumptions about the model’s shock structure and steady-state behavior can be formulated as testable hypotheses on common stochastic trends and cointegration. The basic stationarity assumptions of the monetary model failed to obtain empirical support. They were too restrictive to explain the observed long persistent swings in the real exchange rate, the real interest rates, and the inflation and interest rate differentials.

Forecasting the Crisis of Vietnam's Financial Market by Markov Switching VAR Model

The global economy and financial markets have experienced "The most adverse shock in a century" due to the impact of the Covid-19 epidemic but are also transforming enormously in the digital era. Besides, Vietnam's financial system has been making vital development steps, increasing its resilience. Still, its development prospects depend mainly on the recovery of the global economy and financial markets, the Stability of the economy, and the Stability of the economic stability and sustainability of investor confidence in the market. The Markov Switching Var (MSVAR) model will measure the crisis in the Vietnamese financial system. The research goals reveal that the volatility of macro variables such as the exchange rate (ER), foreign exchange reserves (FR), and the domestic interest rate differential (ID) affects the financial market crisis in Vietnam from 2010 to 2020. According to MSVAR estimation, establishing the time of the financial market crisis correlates with the period of higher volatility in the foreign currency market. Thus, the article's novelty is to proactively seize opportunities development prospects and prevent risks towards sustainable development, and strategic solutions are needed.

A reconsideration of the failure of uncovered interest parity for the U.S. dollar

We reexamine the time-series evidence on uncovered interest rate parity for the U.S. dollar versus major currencies at short-, medium- and long-horizons. The evidence that interest rate differentials predict foreign exchange returns is not stable over time and disappears altogether when interest rates are near the zero-lower bound. However, we find that year-on-year inflation rate differentials predict excess returns – when the U.S. y.o.y. inflation rate is relatively high, subsequent returns on U.S. deposits tend to be high. We interpret this as consistent with the hypothesis that markets underreact initially to predictable changes in future monetary policy. The predictive power of y.o.y. inflation begins in the mid-1980s when central banks began to target inflation consistently and continues in the post-ZLB period when interest rates lose their primacy as a policy instrument. We attempt to address some econometric problems that might bias the conventional Fama (1984) test.

Globalization, long memory, and real interest rate convergence: a historical perspective.

This paper investigates whether the real interest rate parity (RIRP) is valid during the three waves of globalizations that occurred in the last 150 years (1870–1914, 1944–1971, 1989 to the present). If any, these periods should favor RIRP, since globalization is a process where economies and financial markets become increasingly integrated into a global economic system. In contrast to the existing literature, we model the departures from RIRP as a long-term memory process and apply fractional integration methods on a sample of real interest rate differentials of seven developed countries: France, Germany, Holland, Italy, Japan, Spain, and the UK across the three globalization waves paired against the USA. We compute impulse response functions (IRF) to gain further insight into the memory characteristics of the RIRP differential processes and provide half-life estimates. We find that deviations from RIRP are mean reverting, providing robust evidence of real interest rate convergence during the three globalization waves. We shed further light on financial and commodity market integration during the three globalization waves by assessing the memory properties of uncovered interest rate parity (UIP) and relative purchasing power parity (PPP) differential processes. We find that deviations from relative PPP and UIP are not always mean-reverting processes. RIRP, relative PPP, and UIP hold simultaneously only in 7 out of 21 cases; RIRP and UIP hold in 11 out of 21 cases; RIRP hold without the support of relative PPP and UIP in 3 out of 21 cases. Thus, the evidence in favor of real interest rate convergence appears to be driven more by UIP than relative PPP. All these results are, to the authors knowledge, new to the literature.

Do interest rate differentials drive the volatility of exchange rates? Evidence from an extended stochastic volatility model

We study the link between the volatility of exchange rates and interest rate differentials (IRD), motivated by the importance of currency carry trade activities in exchange rate dynamics. We examine this link by means of an extended stochastic volatility model, for which we detail an efficient estimation strategy based on Gaussian mixture sampling and a linearization of the volatility process. We apply this approach to six currency pairs over the period from January 1999 to December 2017. Our results suggest that changes in IRD affect volatility differently for low and high-interest-rate currencies. The volatility reacts strongly and positively to increases in the low interest rate, an effect consistent with the unwinding of carry trade positions. In contrast, the response to a raise in the high interest rate is negative and substantially smaller. In general, we find that the informational content of the interest rate differentials regarding the volatility of exchange rate is greater during and after the global financial crisis, compared to the pre-crisis period. • We study the link between exchange rate volatility and interest rate differentials. • This analysis is conducted by means of an extended stochastic volatility model. • We propose an efficient Bayesian estimation strategy. • A narrowing of absolute rate differentials implies an increase in volatility. • This result suggests the existence of a carry trade channel for developed economies.

Do Exchange Rate and Inflation Matters to Nigerian Economy? New Evidence from Vector Autoregressive (VAR) Approach

Currency fluctuations and inflation are the natural norm for most major economies. Numerous factors influence economic growth, including a country’s exchange rate system performance, the outlook for inflation, and interest rate differentials. These are the most significant factors that hinder the economic growth of every nation. As a result, this analysis investigates the impact of exchange rate and inflation on Nigeria’s growth performance from 1986 to 2021. Impulse response and variance decomposition were estimated. The real gross domestic product (RGDP) was used as a proxy for growth performance, while the inflation rate (IFNR), real exchange rate (REXR), and interest rate (INTR) were also used as proxies. The results of impulse response and variance decomposition estimates in the short-run (third quarter) and long-run (tenth quarter) show that real exchange rate D(REXR), INTR, and IFNR all have a positive impact on RGDP variation, with values of 13.38%, 31.88%, and 22.40%, respectively, in the third quarter. In the long run (the 10th quarter), REXR contributed approximately 28.76% of the variation in RGDP. The interest rate contributed 24.14%, while the IFNR has contributed about 28.27% of the variation in RGDP in the long run. Therefore, summing the contributions of REXR, INTR, and INFR to RGDP, these variables contributed about 81.17% of the variation in RGDP in the long run. Hence, the research concluded that REXR, INTR, and IFNR have a positive effect on growth performance as proxied by RGDP in Nigeria within the period of the research. The research recommended that the government should provide a policy that will reduce the excess growth of aggregate demand (AD) in the economy, which will reduce inflationary pressure, in order to achieve the sustainable development goals (SDGs) of 2030 in Nigeria, which include restoring economic growth and macroeconomic stability through macroeconomic variables such as the exchange rate, inflation, and other significant variables.