DP5527 Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle

Author(s): Hyginus Leon , Lucio Sarno , Giorgio Valente

Publication Date: March 2006

Keyword(s): foreign exchange , uncovered interest parity , forward bias , nonlinearity

JEL(s): F31

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP5527.asp

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.