Uncovered Interest Parity and Carry Trades

Table of Contents

1 Introduction

2 Theoretical Framework

2.1 Uncovered Interest Parity

2.2 The Forward Premium Puzzle

3 Testing of UIP

3.1 Data

3.2 Regression equation and excess return formula

3.3 Results and analysis

4 Discussion of recent findings in literature

4.1 Approaches to explain a violation of UIP

4.1.1 Explanation by risk premium and peso problems

4.1.2 Explanation by irrationality

4.1.3 Explanation by learning problems and market inefficiency

4.2 Approaches to explain a partial holding of UIP

4.2.1 Developed and emerging markets

4.2.2 Short term and long term maturities

5 Consequences of recent innovations in the foreign exchange market

6 Conclusion

7 Bibliography

Research Objectives and Themes

This thesis aims to test the Uncovered Interest Parity (UIP) theory using an OLS regression analysis on bilateral currency pairs to investigate persistent deviations from UIP and the underlying causes of the "forward premium puzzle" in modern financial markets.

• Empirical testing of UIP through OLS regression on major currency pairs against the US Dollar.
• Analysis of excess returns for carry trade strategies, accounting for transaction costs via bid-ask spreads.
• Evaluation of recent academic literature regarding risk premiums, irrational market behavior, and learning problems as explanations for UIP violations.
• Discussion of how recent innovations in foreign exchange markets and central bank policies influence carry trade attractiveness.

Excerpt from the Book

Summary of Chapters

1 Introduction: This chapter introduces the theoretical concepts of UIP and the carry trade strategy, outlines the motivation for the study, and defines the research scope.

2 Theoretical Framework: This chapter provides the macroeconomic background of UIP, the concept of the "forward premium puzzle," and Fama’s initial findings.

3 Testing of UIP: This chapter presents the data selection, the methodology (OLS regression and excess return formulas), and the analysis of empirical results.

4 Discussion of recent findings in literature: This chapter reviews academic approaches to explaining UIP violations, focusing on risk premiums, irrational expectations, and market inefficiencies.

5 Consequences of recent innovations in the foreign exchange market: This chapter discusses how modern market developments and central bank policies impact the future profitability of carry trade strategies.

6 Conclusion: This chapter summarizes the empirical findings, synthesizes the literature review, and offers concluding remarks on the current validity of UIP.

7 Bibliography: This section lists all scientific papers and data sources referenced throughout the thesis.

Keywords

Uncovered Interest Parity, UIP, Carry Trade, Forward Premium Puzzle, Risk Premium, OLS Regression, Foreign Exchange, Excess Returns, Market Inefficiency, Transaction Costs, Exchange Rate, Monetary Policy, Volatility, Bilateral Currency Pairs, Financial Markets.

Frequently Asked Questions

What is the core subject of this thesis?

The thesis examines the Uncovered Interest Parity (UIP) condition and why it is consistently violated in empirical tests, a phenomenon widely known as the "forward premium puzzle" in international finance.

What are the primary themes addressed?

The study covers the mechanisms of carry trade strategies, the statistical testing of UIP, the role of risk premiums, investor irrationality, and the influence of modern central bank policies on currency returns.

What is the main goal of the research?

The primary goal is to empirically test UIP using OLS regression on five popular currency pairs and to reconcile these findings with current academic debates on market deviations.

Which scientific method is applied?

The author implements an OLS regression analysis on bilateral currency pairs, using one-month forward contracts and incorporating bid-ask spreads to account for transaction costs.

What is covered in the main body of the work?

The main body includes a theoretical derivation of UIP and the "forward premium puzzle," a detailed quantitative testing section, and an extensive literature review classifying explanations for UIP violations.

Which keywords characterize this work?

Key terms include Uncovered Interest Parity (UIP), carry trade, forward premium puzzle, risk premium, foreign exchange, OLS regression, and market inefficiency.

How do transaction costs affect the findings in this study?

The study incorporates bid and ask rates to calculate "worst-case" excess returns, highlighting that transaction costs significantly reduce the profitability of carry trades, though they have decreased over time.

Why does the author focus on bilateral currency pairs?

The author argues that in practice, most carry trades are executed as specific bilateral positions rather than broad baskets, and using bilateral pairs allows for the analysis of idiosyncratic risk factors.