Nonlinearity in Deviations From Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle
IMF Working Papers, May 1, 2006
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Bibliographic details
- Authors: Giorgio Valente, Gene L. Leon, Lucio Sarno
- Published: May 1, 2006
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451863963.001
Summary and main findings
- Empirical evidence shows that deviations from uncovered interest rate parity (UIP) display significant nonlinearities.
- These nonlinearities are consistent with theories based on transaction costs or limits to speculation.
- The presence of such nonlinearities suggests that the forward bias documented in the literature may be less indicative of major market inefficiencies than previously thought.
- Monte Carlo experiments demonstrate that if the true process of UIP deviations follows the nonlinear form considered in the paper, estimation of conventional spot-forward regressions would generate the anomalies documented in previous research (the forward bias puzzle).
Methodology and empirical approach
- Empirical analysis focused on testing for significant nonlinearities in deviations from UIP.
- Monte Carlo experiments were used to assess how conventional spot-forward regression estimation behaves when the underlying UIP-deviation process is nonlinear.
- The approach reconciles the paper’s nonlinear evidence with the large empirical literature reporting the forward bias puzzle by showing conventional estimators can produce the documented anomalies under nonlinear UIP deviations.
Implications and interpretation
- Nonlinearities in UIP deviations imply that observed forward bias may reflect market microstructure features (e.g., transaction costs, limits to speculation) rather than broad market inefficiency.
- Results caution against interpreting forward bias in linear spot-forward regressions as definitive evidence of exploitable arbitrage or irrational behavior without considering nonlinear dynamics.