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Review of Finance Vol. 10 No. 3 2006

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

Lucio Sarno1; Giorgio Valente2; Hyginus Leon3

1 University of Warwick and CEPR · 2 Chinese University of Hong Kong · 3 International Monetary Fund

open access

Abstract

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 theseresults 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.

DOI
10.1007/s10679-006-9001-z
Volume
10
Issue
3
Pages
443-482
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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