Do interest rate differentials drive the volatility of exchange rates? Evidence from an extended stochastic volatility model

We study the link between volatility of exchange rates and interest rate differentials (IRD), motivated by importance currency carry trade activities in dynamics. examine this means an extended stochastic model, for which we detail efficient estimation strategy based on Gaussian mixture sampling a linearization process. apply approach to six pairs over period from January 1999 December 2017. Our results suggest that changes IRD affect differently low high-interest-rate currencies. The reacts strongly positively increases rate, effect consistent with unwinding positions. In contrast, response raise high is negative substantially smaller. general, find informational content regarding greater during after global financial crisis, compared pre-crisis period.