Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle

44 Pages Posted: 21 Jun 2006

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 Monetary Authority - Hong Kong Institute for Monetary Research (HKIMR)

Hyginus Leon

International Monetary Fund (IMF)

Multiple version iconThere are 2 versions of this paper

Date Written: May 2006

Abstract

We provide empirical evidence that deviations from uncovered interest rate parity (UIP) display significant nonlinearities, consistent with theories based on transaction costs or limits to speculation. This evidence suggests that the forward bias documented in the literature may be less indicative of major market inefficiencies than previously thought. Monte Carlo experiments allow us to reconcile these results with the large empirical literature on the forward bias puzzle since we show that, if the true process of UIP deviations were of the nonlinear form we consider, estimation of conventional spot-forward regressions would generate the anomalies documented in previous research.

Keywords: Forward bias puzzle, uncovered interest parity, nonlinearity

JEL Classification: C22, F31

Suggested Citation

Sarno, Lucio and Valente, Giorgio and Leon, Hyginus, Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle (May 2006). IMF Working Paper, Vol. , pp. 1-44, 2006. Available at SSRN: https://ssrn.com/abstract=910701

Lucio Sarno (Contact Author)

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

Hong Kong Monetary Authority - Hong Kong Institute for Monetary Research (HKIMR) ( email )

3 Garden Road, 8th Floor
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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