The Solution to the Forward-Bias and Related Puzzles

John E Pippenger

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

Abstract: The forward-bias puzzle is probably the most important puzzle in international finance. But there is a simple solution. Covered interest parity implies that the forward-bias puzzle is the result of two omitted variables: (1) the future change in the forward exchange rate and (2) the future interest rate differential. As Table 3 shows, at least for my data, the downward bias produced by those two omitted variables completely explains the forward-bias puzzle. Covered interest parity also solves three related puzzles.

Keywords: exchange rates; forward bias; covered interest parity; uncovered interest parity, arbitrage, Social and Behavioral Sciences, Business (search for similar items in EconPapers)
Date: 2010-04-01
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