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

Author/Editor:

Giorgio Valente ; Gene L. Leon ; Lucio Sarno

Publication Date:

May 1, 2006

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

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.

Series:

Working Paper No. 2006/136

Subject:

Currencies Exchange rates Financial services Foreign exchange Forward exchange rates Interest rate parity Money Spot exchange rates

English

Publication Date:

May 1, 2006

ISBN/ISSN:

9781451863963/1018-5941

Stock No:

WPIEA2006136

Pages:

44

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