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Bond Convenience Yields and Exchange Rate Dynamics†

Bond Convenience Yields and Exchange Rate Dynamics† AbstractThis paper proposes a new explanation for the failure of Uncovered Interest Parity (UIP) that rationalizes both the classic UIP puzzle and the evidence that the puzzle reverses direction at longer horizons. In the model, excess currency returns arise as compensation for endogenous fluctuations in bond convenience yield differentials. Due to the interaction of monetary and fiscal policy, the impulse response of the equilibrium convenience yield is nonmonotonic, which generates the reversal of the puzzle. The calibrated model fits exchange rate dynamics very well. I also find direct evidence linking convenience yields to excess currency returns. (JEL E43, E52, F31, F41, H63) http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png American Economic Journal: Macroeconomics American Economic Association

Bond Convenience Yields and Exchange Rate Dynamics†

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Publisher
American Economic Association
Copyright
Copyright © 2020 © American Economic Association
ISSN
1945-7715
DOI
10.1257/mac.20170391
Publisher site
See Article on Publisher Site

Abstract

AbstractThis paper proposes a new explanation for the failure of Uncovered Interest Parity (UIP) that rationalizes both the classic UIP puzzle and the evidence that the puzzle reverses direction at longer horizons. In the model, excess currency returns arise as compensation for endogenous fluctuations in bond convenience yield differentials. Due to the interaction of monetary and fiscal policy, the impulse response of the equilibrium convenience yield is nonmonotonic, which generates the reversal of the puzzle. The calibrated model fits exchange rate dynamics very well. I also find direct evidence linking convenience yields to excess currency returns. (JEL E43, E52, F31, F41, H63)

Journal

American Economic Journal: MacroeconomicsAmerican Economic Association

Published: Apr 1, 2020

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