International Finance
Forward discounts

One of the most fundamental theoretical concepts in international finance is uncovered interest parity (UIP). UIP states that a country with high interest rates should have a depreciating currency; indeed, the gain from high interest rates should be offset on average from the capital loss of depreciation. Regressions of ex-post changes in floating exchange rates on appropriate interest differentials typically imply that the high interest rate currency tends to appreciate – the `forward discount puzzle'. In Discussion Paper No. 1090, Robert Flood and Research Fellow Andrew Rose use data from the European Monetary System to find that a large part of the forward discount puzzle vanishes for regimes of fixed exchange rates. That is, deviations from uncovered interest parity appear to vary in a way that is dependent upon the exchange rate regime.

The paper's second contribution to the literature stems from the fact that the ERM has experienced a number of discrete exchange rate realignments since the EMS began in 1979. Many of these realignments were anticipated by the financial markets. Market anticipations of an event which does not occur sufficiently frequently in the sample leads to small-sample bias in UIP regressions. This bias is commonly referred to as the `peso problem'. While there is no guarantee that the 54 realignments which the ERM experienced in the sample are enough to constitute a large sample (especially as these events are not independent across country or time), the authors estimate that the peso problem leads to a bias of around -0.35, the difference between the slope coefficient in the UIP regression when the latter is estimated with and without realignments.

Fixes: Of the Forward Discount Puzzle
Robert P Flood and Andrew K Rose

Discussion Paper No. 1090, January 1995 (IM)