This paper investigates the profitability of carry trades by taking into account the endogeneity of regime switching between low and high states of exchange rate volatility. The analysis uses an endogenous regime switching model with an autoregressive latent factor, in which the future transition between states depends on the current state as well as the realization of the underlying time series. The results show that carry trades are profitable in a regime with low exchange rate volatility, signifying the failure of uncovered interest rate parity (UIP). However, carry trades yield losses in a regime with high exchange rate volatility, which implies a reversion to UIP. The endogenous latent factor obtained from the model represents historical economic downturns associated with carry trade losses well. It also appears to exhibit a similar pattern to those of two measures of uncertainty, macroeconomic uncertainty and economic policy uncertainty. 

JEL Classification: C32; F31; G15
Keywords: Endogenous regime switching model; Carry trades; Exchange rate volatility; Latent factor; Uncovered interest rate parity​