On the role of interest rate differentials in the dynamic asymmetry of exchange rates

• Published in: Economic modelling 2023-12, Vol.129, p.106554, Article 106554
• Main Authors: Hambuckers, J., Ulm, M.
• Format: Article
• Language: English
• Subjects: Dynamic asymmetry; Exchange rate; GARCH; Interest rate differential
• ISSN: 0264-9993
• DOI: 10.1016/j.econmod.2023.106554

Motivated by the lack of empirical evidence in favor of the uncovered interest rate parity rule, we revisit the informational content of interest rate differentials (IRD) to explain daily exchange rates variations. Proposing a novel version of a GARCH model, we allow for the IRD to impact on the time-varying conditional asymmetry of the depreciation rate. We find IRD to be a significant factor for the Euro (EUR), the Swiss franc (CHF), the Swedish Krona, the Japanese Yen and the British Pound. These findings empirically support currency crash theories, suggesting that the larger the difference between interest rates, the more likely the high-yield currency appreciates on average but also exhibits greater risk of a large depreciation. Compared to random walk and buy-and-hold benchmarks, we document superior out-of-sample mean returns of a trading rule exploiting IRD information for EUR and CHF. •We study the role of interest rate diferentals in the asymmetry of exchange rates.•Relying on a novel GARCH model, we find a significant efect for advanced economies.•The high-yield currency appreciates, although at the cost of a higher crash risk.•These efects can be exploited in a profitable trading rule for EUR and CHF.•The results provide empirical evidence for currency crash risk theories.