Nonlinearity in deviations from uncovered interest parity: an explanation of the forward bias puzzle
Sarno, Lucio, Valente, Giorgio and Leon, H. L. (Hyginus Lambert) (2006) Nonlinearity in deviations from uncovered interest parity: an explanation of the forward bias puzzle. Discussion Paper. London: Centre for Economic Policy Research (Great Britain). Discussion paper (Centre for Economic Policy Research (Great Britain)) (No.552).
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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.
|Item Type:||Working or Discussion Paper (Discussion Paper)|
|Subjects:||H Social Sciences > HG Finance|
|Divisions:||Faculty of Social Sciences > Economics|
|Library of Congress Subject Headings (LCSH):||Interest rates, Foreign exchange futures, Foreign exchange rates, Nonlinear theories|
|Series Name:||Discussion paper (Centre for Economic Policy Research (Great Britain))|
|Publisher:||Centre for Economic Policy Research (Great Britain)|
|Place of Publication:||London|
|Official Date:||March 2006|
|Number of Pages:||49|
|Status:||Not Peer Reviewed|
|Access rights to Published version:||Open Access|
 Backus, D.K., Gregory, A.W. and Telmer, C.I. (1993) Accounting for Forward Rates in Markets for Foreign Currency, Journal of Finance 48, 1887-1908.
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