Limits to Speculation and Nonlinearity in Deviations from Uncovered Interest Parity: Empirical Evidence and Implications for the Forward Bias Puzzle

41 Pages Posted: 6 May 2004

See all articles by Lucio Sarno

Lucio Sarno

City University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR)

Giorgio Valente

Hong Kong Institute for Monetary and Financial Research (HKIMR)

Hyginus Leon

International Monetary Fund (IMF)

Date Written: October 2003

Abstract

We examine empirically the hypothesis that limits to speculation in the foreign exchange market may induce nonlinearities in the spot-forward relationship and in the process driving the deviations from the uncovered interest rate parity (UIP) condition. Our empirical results provide strong evidence of nonlinearities which are consistent with a model of deviations from UIP with two extreme regimes: one regime with persistent but tiny deviations from UIP, and another regime where UIP holds. In a battery of Monte Carlo experiments, we show that if the true data generating process of UIP deviations were of the nonlinear form we consider, estimation of conventional spot-forward regressions would generate the well known forward bias puzzle and the predictability of foreign exchange excess returns documented in the literature. In turn, these findings have implications for the economic significance of the statistical rejection of foreign exchange market efficiency.

Keywords: foreign exchange, uncovered interest parity, forward bias, nonlinearity

JEL Classification: F31

Suggested Citation

Sarno, Lucio and Valente, Giorgio and Leon, Hyginus, Limits to Speculation and Nonlinearity in Deviations from Uncovered Interest Parity: Empirical Evidence and Implications for the Forward Bias Puzzle (October 2003). EFMA 2004 Basel Meetings Paper. Available at SSRN: https://ssrn.com/abstract=470643 or http://dx.doi.org/10.2139/ssrn.470643

Lucio Sarno

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Giorgio Valente (Contact Author)

Hong Kong Institute for Monetary and Financial Research (HKIMR) ( email )

One Pacific Place, 10th Floor
88 Queensway
Hong Kong
China

Hyginus Leon

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States
202-623-6115 (Phone)
202-589-6115 (Fax)

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