Working Paper: CEPR ID: DP14497
Authors: Giancarlo Corsetti; Emile Marin
Abstract: A long-standing puzzle in international finance is that a positive interest rate differen- tial systematically forecasts an exchange rate appreciation—the Uncovered Interest Parity (UIP) puzzle. Hence, a carry trade portfolio long in high yield currency bonds funded by borrowing in low yield currencies can be expected to yield positive profits. Following the Great Financial Crisis, however, the sign of the puzzle has changed—positive differentials forecast excessive depreciation—and carry trade has withered after the large losses suffered by investors in 2007-2008. In this paper, we use a century-long time series for the GBP/USD exchange rate to show that a sign switch is neither new, nor, arguably, a new puzzle. First, it is not new in the data—by virtue of a long sample featuring infrequent, non-overlapping currency crashes, we document that switches systematically occur in crises such as the Great Depression in the 1930s and the exchange rate turmoil of the 1990s. However, UIP devi- ations, sharp in either direction for short- to medium-horizon portfolios, remain small to almost negligible for long-horizon investment portfolios. Second, we argue that our century- long evidence is consistent with models featuring a time-varying probability of disasters or ’Peso events,’ specified so to account for the difference in UIP deviations in crisis and nor- mal times, as well as for a decreasing term structure of carry trade returns that on average characterize the data.
Keywords: Uncovered Interest Parity; Peso Problem; Great Depression; Currency Crises; Carry Trade; Fama Puzzle
JEL Codes: F31; F41; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| UIP failure in normal times (J65) | UIP reversal during crises (H12) |
| Probability of extreme events (C46) | Pricing of carry trades (F31) |
| Interest rate differentials (E43) | Exchange rate movements (F31) |
| Crisis periods (G01) | Fama coefficient becomes positive and exceeds one (C29) |
| Fama coefficient (C29) | Depreciation of high-yield currencies (F31) |
| Economic context (N00) | Relationship between interest rate differentials and exchange rate movements (F31) |