Wednesday, November 28, 2007

Carry trades and volatility –

Carry trades have declined with the increase in interest rate volatility. This relationship is actually predicted when tests of unbiased forward rates are adjusted for changes in volatility. One of the empirical relationships which have driven carry trades is the fact that the forward rate is a biased predictor of future spot rates. Given the strong evidence of this bias, there is a strong level of confidence with the doing carry-type trades. However, recent research from the Koopmans Research Institute suggests that the results that reject uncovered interest rate parity are themselves biased by the differences in volatility of interest rates.

http://www.uu.nl/uupublish/content-cln/06-162.pdf

The result of the research by Hadzi-Vaskov and Kool show that uncovered interest rate parity cannot be rejected during those periods when the anchor interest rate is highly volatile. This could simply be a result of the estimation procedures used but previous researchers, but I would suggest that it is also related to the fact that investors do not want to undertake carry trades during periods of high volatility. The risk from holding carry trades is higher so there is less pressure pushing rates away from uncovered interest rate parity.

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