## 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

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### 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.

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/nonlinearity-in-deviations-from-uncovered-interest-parity-an-explanation-of-the-forward-bias-19169_