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Regime Switches in Exchange Rate Volatility and Uncovered Interest Parity

November 2007
Hibiki Ichiue*1
Kentaro Koyama*2

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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.

Uncovered interest rate parity, Forward discount puzzle, Carry trade, Markov-switching model, Bayesian Gibbs sampling

We would like to thank Naohiko Baba, James D. Hamilton, Keiji Kono, Mototsugu Shintani, Toshiaki Watanabe, Tomoyoshi Yabu, and the staff at the Bank of Japan for their helpful comments. The views expressed here are solely ours, and do not necessarily reflect those of the Bank of Japan.

  • *1 Research and Statistics Department, Bank of Japan
  • *2 Financial Markets Department, Bank of Japan


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