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

Giorgio Valente, Gene Leon and Lucio Sarno

No 2006/136, IMF Working Papers from International Monetary Fund

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: WP; exchange rate; Sharpe ratio; Forward bias puzzle; uncovered interest parity; nonlinearity; Fama regression; UIP deviation; deviations from UIP; excess return; Interest rate parity; Exchange rates; Forward exchange rates; Spot exchange rates; Currencies; Global (search for similar items in EconPapers)
Pages: 44
Date: 2006-05-01
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Citations: View citations in EconPapers (122)

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Journal Article: Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle (2006)
Working Paper: Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle (2006)
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