The Forward-Bias Puzzle: A Solution Based on Covered Interest Parity

John Pippenger

University of California at Santa Barbara, Economics Working Paper Series from Department of Economics, UC Santa Barbara

Abstract: When covered interest parity holds, as appears to be the case, the forward exchange rate is not the expected future spot rate. As a result: (1) in general covered and uncovered interest parity are mutually inconsistent; (2) the standard equation that produces the forward-bias puzzle is miss-specified. When covered interest parity is used to correct that miss-specification, the puzzle disappears. Forward premiums are unbiased estimates of future changes in exchange rates. This solution for the forward-bias puzzle holds whether or not there is a risk premium. It also solves two subsidiary puzzles.

Keywords: exchange rates; forward bias; covered interest parity; arbitrage, Social and Behavioral Sciences (search for similar items in EconPapers)
Date: 2009-10-01
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