FX Dynamics, Limited Participation, and the Forward Bias Anomaly

28 Pages Posted: 30 Apr 2005

See all articles by Miguel Villanueva

Miguel Villanueva

Crowninshield Financial Research; Boston University - MET

Abstract

Standard foreign exchange (FX) models with goods price stickiness and instantaneous asset market adjustments imply FX overshooting (Dornbusch, 1976), which can explain the forward bias anomaly. Lyons (2001) explained the anomaly via limited participation of FX speculators due to Sharpe ratios lower than equity market alternatives, which implies FX undershooting to interest differential shocks. I derive the time-series implications of overshooting and undershooting for the joint forward/spot FX dynamics in a vector error correction model. I use generalized impulse response analysis (Pesaran and Shin, 1998) to test those implications. All FX studied (pound, deutsch mark, French franc, yen, and Canadian dollar) have dynamics consistent with undershooting during the period from 1975 to 1998.

Keywords: Forward-bias, generalized impulse response, limited participation, overshooting, undershooting

JEL Classification: G15, F31, C32

Suggested Citation

Villanueva, Miguel, FX Dynamics, Limited Participation, and the Forward Bias Anomaly. Available at SSRN: https://ssrn.com/abstract=564341

Miguel Villanueva (Contact Author)

Crowninshield Financial Research ( email )

56 Harvard St
Brookline, MA 02445
United States
7812374800 (Phone)

Boston University - MET ( email )

United States

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