Regime Switches in Exchange Rate Volatility and Uncovered Interest Parity

Lower-interest-rate currencies tend to depreciate relative to higher-interest-rate currencies. This observation is inconsistent with a popular theory, uncovered interest parity (UIP). According to market participants' views, this is caused by the carry-trade activities in a low-volatility environment. This paper investigates how exchange rate volatilities influence the failure of UIP by using a regime-switching model, which is less restricted than those used in the literature. We estimate this model using a new method of Bayesian Gibbs sampling, which enables us to examine higher-frequency state transmissions and, at the same time, avoid possible estimation biases arising from the use of overlapping data. The main findings are as follows. First, statistical tests support our model in comparison with the alternatives. The evidence suggests that regime switches in exchange rate returns should be interpreted as switches in the relationship between the returns and interest rate differentials, which may be interpreted as switches between the carry trade and its unwinding. Second, low-interest-rate currencies appreciate less frequently, but once it occurs, its movement is faster than when they depreciate. This may be because the appreciation is influenced by a rapid unwinding of the carry trade. Third, a low volatility tends to cause UIP failure. In fact, the reverse is also true. That is, UIP failure contributes to maintaining a lower-volatility environment, which may imply that a high volatility does not tend to occur until an unwinding of the carry trade. These results imply that the low-volatility environment and UIP failure are mutually dependent. Finally, the second and third findings are more evident for shorter maturities, and this may imply that UIP failure is influenced by short-term speculations. All 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