The uncovered interest rate parity anomaly and trading activity by non-dealer financial firms

•Foreign exchange markets have experienced rapid growth in trading by non-dealer financial firms.•We hypothesize that these new market participants are likely to exploit the excess returns from the uncovered interest rate parity (UIP) anomaly.•Empirical study of six major currency pairs over 1992-2010 shows that increased trading by non-dealer financial firms mitigates the UIP anomaly.•In contrast, the growth in interdealer and retail-related foreign exchange trading has no impact on the UIP anomaly

Since the 1990s there has been a substantial increase in foreign exchange market trading by non-dealer financial firms. Non-dealer financial firms comprise a market segment that includes hedge funds and mutual funds, among others. We investigate whether the growth of non-dealer financial firm trading affected the uncovered interest rate parity (UIP) anomaly, a phenomenon that seems to offer opportunities for excess returns. We find that the growth in trading volume by non-dealer financial firms is associated with some mitigation in the UIP anomaly. In contrast, growth in dealer-to-dealer and dealer-to-nonfinancial firm trading volume has no impact on the anomaly.