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

Hyginus Leon, Lucio Sarno () and Giorgio Valente ()

No 5527, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We provide empirical evidence that deviations from the uncovered interest rate parity (UIP) condition display significant nonlinearities, consistent with theories based on transactions 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: foreign exchange; forward bias; nonlinearity; uncovered interest parity (search for similar items in EconPapers)
JEL-codes: F31 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-fmk and nep-ifn
Date: 2006-03
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Related works:
Working Paper: Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle (2006)
Journal Article: Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle (2006)
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