Bond convenience yields and exchange rate dynamics

Abstract

This paper proposes a new explanation for the failure of Uncovered Interest Parity (UIP) that rationalize 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 non-monotonic, which generates the reversal of the puzzle. The model fits exchange rate dynamics very well, and I also find direct evidence that convenience yields indeed drive excess currency returns.