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

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

Publication Date: March 2006

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

Programme Area(s): Financial Economics and International Macroeconomics

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 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.

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Bibliographic Reference

Leon, H, Sarno, L and Valente, G. 2006. 'Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=5527