Recently, the popular international investment strategy is the “Carry trade”. It was build by borrowing the currency from the low interest rate country and investing in the high interest rate country. However, according to the international financial theory, i.e. the uncovered interest parity (UIP), the country with high interest rate their exchange rate would depreciation in the future. No matter how the investors earn from the differential interest rate between the two countries would offset by the exchange rate differential. Regarding the UIP, the earliest famous literature (Meese and Rogoff’s (1983) and Fama (1984)) used the exchange rate data to test it.
Meese and Rogoff’s (1983) assumed the exchange rates following the “near random walk” model and provided the evidence to reject UIP. Fama (1984) applied the concept of forward rate contained the time varying premium to analysis the relationship between the forward exchange rate and sport exchange rate and pointed out the high interest rate currency tend to appreciate rather than depreciate. Besides, Froot and Thaler (1990) replaced time varying premium with the mean return theory to explain the foreign exchange anomalies.
Empirical studies have used the non-linear model to fit the foreign exchange. Sarno et al. (2006) provided the strong evidence on the major bilateral dollar exchange rates is nonlinearity. And their Monte Carlo evidence constructing on the nonlinear model can explain the anomalies on the forward bias puzzle. Ichiue and Koyama (2008) provided the regime switch model to detect how the exchange rate volatility influenced the UIP. The failures of the UIP was contributed the lower-volatility environment.
In particular, they argued that the carry trade it’s rapidly unwinding would affected the exchange rate volatility. The recently Christiansen et al. (2009) analyzed the carry trade return by using the daily data from 1985 to 2008 with the multi-factor model. Their main findings include the carry trade return has the highly regime dependence. In addition, the FX volatility and TED spread had more influence on the carry trade strategy than FX market liquidity did.
Download
The trading strategy of carry trade using the generalized threshold autoregressive model
