Carry trade, uncovered interest parity and monetary policy

It is well documented in the literature that identified vector autoregression (VAR) models often produce puzzling results when the effect of unexpected monetary policy movements is estimated. Many authors find that raising interest rate generates protracted appreciation of the exchange rate (the so-called delayed overshooting puzzle) which is in contradiction with traditional theory of exchange rate dynamics based on uncovered interest parity. Since the dynamics of exchange rate is determined to a substantial extent by carry traders, we investigate the behaviour of the exchange rate and carry trade activity within the same VAR for a panel of small open economies. We identify structural shocks by allowing the interest rate and exchange rate to react simultaneously to monetary policy and changes in expected risk premium. Our results show that the delayed overshooting is not a robust finding. Exchange rate appreciation and carry trade movements take place almost on impact after an unexpected interest rate hike. Roughly half of the variation in carry trade positions can be explained by domestic interest rate changes and risk premium shocks.