Is the Forward Bias Economically Small? Evidence from European Rates

Journal of International Money and Finance, Vol. 27, pp. 1284–1302, 2008

19 Pages Posted: 14 Oct 2009

See all articles by Piet Sercu

Piet Sercu

FEB at KU Leuven

Martina L. Vandebroek

Katholieke Universiteit Leuven - Faculty of Business and Economics

Xueping Wu

City University of Hong Kong (CityUHK) - Department of Economics & Finance

Date Written: 2008

Abstract

For the purpose of testing uncovered interest parity (UIP), rates of European currencies against the Mark offer a distinct advantage: the admissible band of the Exchange Rate Mechanism (ERM) induces statistically significant mean-reversion in weekly rates. Thus, unlike for freely floating rates, there is an expectation signal that has nontrivial variation and is sufficiently traceable for research purposes. When running the standard regression tests of the unbiasedexpectations hypothesis at the one-week horizon, we nevertheless obtain essentially zero coefficients for intra-EMS exchange rates (and the familiar negative coefficients for extra-EMS rates). Even more puzzlingly, lagged exchange-rate changes remain significant when added to the regression, a feature that seems hard to explain as a missing-variable effect. The deviation from UIP is significant not just statistically but also economically: trading-rule tests reveal that for sufficiently large filters the average profit per trade exceeds transaction costs, and that cumulative gains can be quite impressive. The size of the profits and the patterns from buy versus sell decisions also allow us to reject the hypotheses of either a risk premium or peso issues about realignments as sufficient explanations.

Keywords: Forward bias, Transaction costs, Trading rule, EMS, ERM

JEL Classification: F31

Suggested Citation

Sercu, Piet M. F. A. and Vandebroek, Martina L. and Wu, Xueping, Is the Forward Bias Economically Small? Evidence from European Rates (2008). Journal of International Money and Finance, Vol. 27, pp. 1284–1302, 2008, Available at SSRN: https://ssrn.com/abstract=1487010

Piet M. F. A. Sercu (Contact Author)

FEB at KU Leuven ( email )

Naamsestraat 69
Faculty of Economics and Business
Leuven, 3000
Belgium
+32 16 32 67 56 (Phone)
+32 16 32 67 32 (Fax)

Martina L. Vandebroek

Katholieke Universiteit Leuven - Faculty of Business and Economics ( email )

Naamsestraat 69
B-3000 Leuven
Belgium

Xueping Wu

City University of Hong Kong (CityUHK) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong
+852 3442 7577 (Phone)
+852 3442 0195 (Fax)

HOME PAGE: http://personal.cityu.edu.hk/~efxpwu/

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