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Nonlinearity in Deviations From Uncovered Interest Parity

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  • Giorgio Valente
  • H. L. Leon
  • Lucio Sarno

Abstract

We provide empirical evidence that deviations from uncovered interest rate parity (UIP) display significant nonlinearities, consistent with theories based on transaction 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 Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/136.

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Length: 44
Date of creation: 01 May 2006
Date of revision:
Handle: RePEc:imf:imfwpa:06/136

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Keywords: Exchange rates; Interest rates; exchange rate; foreign exchange; equation; forward exchange; nonlinearity; survey; forward exchange rates; predictability; statistics; standard deviation; autocorrelation; statistic; foreign exchange market; predictions; standard errors; nonlinear model; exchange rate expectations; time series; exchange rate changes; samples; nonlinear models; empirical framework; dollar exchange rates; spot exchange rate; exchange markets; foreign exchange markets; econometrics; significance levels; bootstrap; exchange rate movements; logarithm; sample sizes; significance level; forecasting; random walk; spot exchange rates; linear model; correlation; forward exchange rate; probabilities; exchange rate dynamics; orthogonality; monte carlo methods; empirical model; home currency; exchange rate determination; covariance; exchange rate change; foreign exchange risk; equations; linear regression; general equilibrium models; exchange risk; exchange rate economics; cointegration; random numbers; prediction; sample size; covariances; horizontal axis; statistical inference; flexible exchange rates; linear time; exchange rate volatility; standard deviations; linearity hypothesis; stochastic differential equation; real exchange rate; estimation of equation; currency markets; sampling; exchange rate forecasting; nominal exchange rates; correlations; exchange rate variances; mathematics; exchange rate data; random walk process; simulation results; explanatory power; foreign exchange contracts; constant term; nonlinear regression; exchange rate theory; multiple exchange rate; asymptotic distribution; monte carlo simulations; linear regressions; statistical significance; stochastic process; exchange rate need; diffusion process;

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References

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