Tracking the Yen Carry Trade: Evidence from a Regime Switching Approach

The UIP theorem has had very little empirical support over the past 25 years. Moreover, it has been shown that high-rate currencies have tended to appreciate and low-rate currencies to depreciate, the reverse of theory. The failure of UIP has been no secret to participants in currency markets, where the carry trade, which is essentially a bet against UIP, has become a very popular investment strategy, underpinned by low exchange rate volatility and persistent interest rate differentials. In this paper, I investigate the role that exchange rate volatility plays in the failure of UIP and hence in the build-up of yen carry trade positions. I specify a Markov-switching version of the UIP equation with time-varying transition probabilities. Empirical evidence indicates the presence of a so-called “carry trade” regime, whose features are compatible with the presence of carry trade activities. Moreover, it is confirmed that both an increase in exchange rate volatility and a decrease in expected interest rate differentials lead to a higher probability of carry trade unwinding. Finally, the inclusion of a time-varying risk premium as additional regressor in the UIP equation leaves the results unchanged, indicating the robustness of the nature of the relationship between exchange rate volatility and carry trades.