The Forward Bias Puzzle and Nonlinearity in Deviations from Uncovered Interest Parity: A New Perspective

39 Pages Posted: 26 Feb 2005

See all articles by Giorgio Valente

Giorgio Valente

Hong Kong Institute for Monetary and Financial Research (HKIMR)

Lucio Sarno

University of Cambridge - Judge Business School; Centre for Economic Policy Research (CEPR)

Hyginus Leon

International Monetary Fund (IMF)

Date Written: January 2005

Abstract

We provide empirical evidence that deviations from the uncovered interest rate parity (UIP) condition display significant nonlinearities, which have a natural interpretation consistent with several recent theories based on transactions costs or limits to speculation in the foreign exchange market. This evidence suggests that the forward bias documented in the literature may be less indicative of major inefficiencies in the foreign exchange market than previously thought. Further, Monte Carlo experiments allow us to reconcile our results with the large empirical literature on the forward bias puzzle since we show that, if the true data generating process of UIP deviations were of the nonlinear form we consider, estimation of conventional linear spot-forward regressions would generate the well known anomalies documented in much previous research.

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

JEL Classification: F31

Suggested Citation

Valente, Giorgio and Sarno, Lucio and Leon, Hyginus, The Forward Bias Puzzle and Nonlinearity in Deviations from Uncovered Interest Parity: A New Perspective (January 2005). EFA 2005 Moscow Meetings Paper, Available at SSRN: https://ssrn.com/abstract=673722 or http://dx.doi.org/10.2139/ssrn.673722

Giorgio Valente

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

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

Lucio Sarno (Contact Author)

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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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