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even stronger positive cross-sectional correlation between carry trade returns and the interest rate differential. The only exception to this relationship is Singapore. Interestingly, the New Zealand dollar displays the highest interest rate differential along with the highest carry trade returns. Finally, currencies that appreciated the most, such as the Japanese Yen, the New Zealand dollar, and the Norwegian krone also display the highest average volatilities. This suggests that there is good reason for traders to pay attention to the exchange rate volatilities.

Table 1 – Sample Statistics

i* i

-0.001

-0.001

0.006

-0.005

-0.009

-0.004

0.003

-0.001

-0.004

-0.002

(0.002)

(0.004)

(0.004)

(0.004)

(0.003)

(0.006)

(0.002)

(0.005)

(0.003)

(0.006)

CAN

GER

JAP

KOR

NZD

NOR

SIN

SWE

U.K.

TOT

-0.006 (0.045)

-0.011 (0.049)

-0.006 (0.048)

0.004 (0.057)

-0.006 (0.067)

-0.008 (0.063)

-0.004 (0.025)

-0.004 (0.062)

0.001 (0.051)

-0.005 (0.053)

-0.007 (0.045)

-0.012 (0.050)

0.000 (0.049)

-0.001 (0.056)

-0.015 (0.067)

-0.012 (0.063)

-0.001 (0.025)

-0.005 (0.062)

-0.004 (0.050)

-0.006 (0.053)

*

0.001 (0.006)

0.002 (0.006)

0.006 (0.007)

-0.002 (0.008)

-0.001 (0.007)

0.001 (0.010)

0.002 (0.009)

0.001 (0.007)

0.001 (0.007)

0.001 (0.008)

π π

VX

8.610 (3.165)

10.155 (3.008)

10.015 (2.637)

9.268 (7.243)

12.861 (3.484)

11.412 (3.172)

5.246 (1.825)

11.454 (3.163)

8.994 (3.074)

9.779 (4.221)

q

0.846 (0.136)

0.499 (0.145)

5.389 (0.069)

3.085 (0.131)

-1.093 (0.201)

2.442 (0.134)

1.141 (0.059)

2.726 (0.141)

0.119 (0.102)

1.684 (1.829)

e m

Individual Countries

Notes: Sample means and sample standard deviations (in parenthesis) for the full sample, December 2000 to March 2009. The units for exchange rate changes, carry return, interest rate differential, and inflation differential are all quarterly changes. Multiplying these by 100 delivers quantities in percentages. VX is the standard deviation of exchange rate changes derived from 3-month FX options. Since raw data for calculating standard deviations is in percentage changes of exchange rates, the unit for VX is also in percentage changes.

3

Statistical Design

The available data described in the previous section restrict the empirical methods that we can pursue. For this reason, we will conduct the analysis in two parts. First, we investigate the dynamic interactions of the UIP and PPP conditions, and volatility with exchange rates using quarterly data. We aggregate the data to reflect the availability of

8

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