A Liquidity-Based Explanation of FX Carry Strategy

#5 – FX Carry Trade

Authors: Jung, Lee

Title: A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2685534

Abstract:

A new monetary theory is set out to resolve the "Uncovered Interest Parity (UIP)" Puzzle. It explores the possibility that liquidity properties of money and nominal bonds can account for the puzzle. A key concept in our model is that nominal bonds carry liquidity premia due to their medium of exchange role as either collateral or means of payment. In this framework no-arbitrage ensures a positive comovement of real return on money and nominal bonds. Thus, when inflation in one country becomes relatively lower, i.e., real return on this currency is relatively higher, its nominal bonds should also yield higher real return. We show that their nominal returns can also become higher under the economic environment where collateral pledgeability and/or liquidity of nominal bonds and/or collateralized credit based transactions are relatively bigger. Since a currency with lower inflation is expected to appreciate, the high interest currency does indeed appreciate in this case, i.e., the UIP puzzle is no longer an anomaly in our model. Our liquidity based theory can in fact help understanding many empirical observations that risk based explanations find difficult to reconcile with.

Notable quotations from the academic research paper:

"The vast majority of the literature on UIP puzzle is empirical, and very few theoretical attempts have been made to tackle the puzzle. Even among the theoretical literature, no consensus seems to have been reached. For instance, most prevailing theories revolve around the idea that the failure of the UIP has a close connection with the way the risk premium behaves. Nevertheless, many recent studies have become critical of these risk-based explanations. To that end, we take an alternative approach in this paper that the UIP violation might be attributed to endogenous liquidity properties of money and bonds.

In our microfounded monetary model of international asset pricing, the UIP does not have to hold uniformly. In particular, the negative relationship between anticipated inflation and nominal bond yield is shown to be sufficient for the UIP deviation. Crucially, our framework implies that nominal bonds must exhibit relatively high enough liquidity premia in order to guarantee the sufficient condition. We show in the model that the sufficiently higher liquidity premia of bonds can be indeed achieved when the portion of collaterlized-credit-transaction-based pairwise meetings is large and/or the pledgeability of bonds as collateral is high and/or exogenous illiquidity discount on bonds as a direct means of payment is low.

One may question if our framework where bonds exhibit as high liquidity premia as money is empirically substantive. One can then address potential concerns. First, not every nominal bonds, especially those issued by emerging economies, are same as the U.S. Treasury bonds. Second, the bond liquidity is surely time-varying, e.g., extreme dry-up of bond liquidity during the recent liquidity crunch episode.

Very interestingly, these two issues are precisely what leads to the non-uniform UIP deviation in our framework. Put it differently, our model implies that the sufficient condition for the UIP deviation cannot be met whenever bonds are not liquid enough. This bond illiquidity is one of the defining characteristics of emerging market bonds and the liquidity crisis. Thus, our model predicts that the UIP should be confined to emerging economies and the liquidity crunch period. These two predictions are well supported by prominent empirical studies."


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