Risk Premiums, Market Volatility, and Exchange Rate Dynamics: Evidence from the Yen Carry Trade

Persistent deviations from Uncovered Interest Rate Parity (UIRP) represent a central puzzle in international finance and a key source of currency risk for global investors. This study examines the UIRP puzzle in the JPY/USD market through the lens of financial risk transmission, focusing on how risk premiums, liquidity conditions, and relative equity market performance jointly shape short-run exchange rate dynamics. Using daily data from 2018 to 2024, we employ a vector autoregression (VAR) framework to capture the endogenous interactions between change in the interest rate differentials, foreign exchange liquidity, global risk indicators (including the VIX, oil price shocks, and currency risk reversals), and relative equity returns consistent with the Uncovered Equity Parity (UEP) hypothesis. The results reveal that traditional interest rate differentials do not directly explain short-term exchange rate movements, confirming persistent UIRP deviations. Instead, risk-related financial channels act as indirect financial risk transmission channels. Shocks to global risk sentiment and currency risk premiums significantly affect JPY/USD returns, while relative equity market performance emerges as a key intermediary linking risk conditions to exchange rate adjustments. The findings also support the Japanese Yen’s continued role as a safe-haven currency during periods of heightened market uncertainty and underline the importance of carry trade dynamics in amplifying risk-driven exchange rate fluctuations. Overall, this study highlights the importance of integrating financial risk measures and portfolio-based transmission channels into exchange rate models. The results have direct implications for risk management, currency exposure hedging, and the assessment of systemic risk spillovers across financial markets.