Failure of UIP: Reasons and implications for carry trade

Abstract

Very well-documented phenomenon in literature regarding exchange rates is the massive failure of the UIP. This has a very significant implication for investors who take part in carry trade or raise debt overseas (FCCBs or ECBs) or have an exposure to foreign exchange risk from their businesses. The standard Chicago/Efficient markets explanation is time-varying risk premia (similar to an insurance premium). But the gap between R and R and the change in the spot rate are too large and variable to be convincingly explained by this. The Behavioral Finance approach talks about momentum investing but that by itself does not explain why the high R currency is the one that usually tends to rise. To begin with, we note that in financially liberalized emerging economies, most high frequency movements in spot currency are correlated with equity price changes. They have very little to do with R and R. At much lower frequencies, say five to ten years, UIP performs somewhat better. Second crucial point to note is that although R and R are exogenous from the UIP condition framework, they reflect broader underlying macro fundamentals. Ignoring inflation (as for the standard 3 month horizons) the levels and changes will be mostly related to real values. Booming economies tend to have high credit demand and also the central banks tend to tighten to avoid overheating. Hence the booming economy will have high R. Reverse for the slumping economy. It will have a low R. This explains USA versus Japan during the late 1990s dotcom boom and beyond.