Essays in international finance

Abstract

This thesis investigates FX market characteristics of emerging markets by exam-ining the uncovered and covered interest parity deviations, There is an extensive literature studying parity conditions in the currency markets. However, we mainly focus on the violation of the parity conditions, especially during post financial crisis period. In the first chapter, we study carry trades which is a well known violation of the so-called uncovered interest-rate parity (UIP). We show that the carry strategy matters in the emerging markets in the sense that the dollar neutral carry strat-egy outperforms the dollar carry strategy. We also show that carry trade is not a profitable strategy, compared to the returns from U.S. stocks and/or U.S. dollar risk-free rate. The findings indicate that risk factors explain the dollar carry strate-gies better than the dollar neutral strategy particularly in the post-crisis period. Because emerging markets are riskier than developed ones, investors are expected to hedge using FX options. However, the evidence suggest that hedging carry trade is not a good idea in the emerging markets because crash risk that is priced in the options seems to evaporate carry profits. In the second chapter, we study de-viations from covered interest parity (CIP) for six emerging market economies: Hungary, Mexico, Poland, Russia, South Africa, Turkey, using daily data following the global financial crisis. After documenting large and persistent discrepancies between January 2010 and July 2018, cost of illiquidity and interest differentials are found to be main drivers of CIP deviations in the emerging countries. We find that the impact of credit risk on CIP deviations may take two forms. In low-carry currencies, the well-known mechanism for credit risk operates so that the increase in credit risk exacerbates CIP deviations. Conversely, in high-carry currencies, the high usage of FX swaps makes swap rates react more than domestic rates, which causes CIP to decrease.