A Resolution of the Forward Discount Puzzle

Jose Olmo and Keith Pilbeam ()
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Keith Pilbeam: Department of Economics, City University, London, http://www.city.ac.uk/economics/staff/pilbeam/index.html

No 07/10, City University Economics Discussion Papers from Department of Economics, City University, London

Abstract: We argue that the forward discount puzzle is primarily a statistical phenomenon and that statistical rejections of Uncovered Interest Parity do not necessarily constitute valid rejections of market efficiency. We find by using a Taylor expansion a theoretical negative bias in existing regressions of UIP. We propose two alternative tests for market efficiency, one of which is designed to measure the degree of market inefficiency. Our results from these tests indicate that for all four of the bilateral dollar parities studied the foreign exchange market is efficient despite decisive clear rejections of UIP using the conventional regression approach.

Keywords: Forward discount puzzle; Efficient Market Hypothesis; Jensen’s inequality; Taylor expansion; 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-ifn
Date: 2007-05
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Persistent link: http://EconPapers.repec.org/RePEc:cty:dpaper:07/10

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