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The solution to the forward-bias puzzle

  • Pippenger, John
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    Although it has taken some 30 years to find, the solution to the forward-bias puzzle is straightforward. The standard test equation that produces the puzzle is missing two variables that covered interest parity implies should be included. For my data, those two missing variables explain the downward bias in the forward-bias puzzle. Covered interest parity also solves another closely related puzzle. The variance for changes in exchange rates is 100-200 times larger than the variance in forward premiums.

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    File URL: http://www.sciencedirect.com/science/article/B6VGT-51TPVSH-1/2/019b7e4957a33da8a1f9926322eede29
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    Article provided by Elsevier in its journal Journal of International Financial Markets, Institutions and Money.

    Volume (Year): 21 (2011)
    Issue (Month): 2 (April)
    Pages: 296-304

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    Handle: RePEc:eee:intfin:v:21:y:2011:i:2:p:296-304
    Contact details of provider: Web page: http://www.elsevier.com/locate/intfin

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    1. Giorgio Valente & H. L. Leon & Lucio Sarno, 2006. "Nonlinearity in Deviations From Uncovered Interest Parity; An Explanation of the Forward Bias Puzzle," IMF Working Papers 06/136, International Monetary Fund.
    2. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," International Trade 0012003, EconWPA.
    3. Jeffrey Frankel & Jumana Poonawala, 2006. "The Forward Market in Emerging Currencies: Less Biased Than in Major Currencies," NBER Working Papers 12496, National Bureau of Economic Research, Inc.
    4. Sercu, Piet & Vinaimont, Tom, 2006. "The forward bias in the ECU: Peso risks vs. fads and fashions," Journal of Banking & Finance, Elsevier, vol. 30(8), pages 2409-2432, August.
    5. Richard T. Baillie & Rehim Kilic, 2005. "Do Asymmetric and Nonlinear Adjustments Explain the Forward Premium Anomaly?," Working Papers 543, Queen Mary University of London, School of Economics and Finance.
    6. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2006. "Arbitrage in the Foreign Exchange Market: Turning on the Microscope," SIFR Research Report Series 42, Institute for Financial Research.
    7. Chakraborty, Avik & Evans, George W., 2008. "Can perpetual learning explain the forward-premium puzzle?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 477-490, April.
    8. Nathan S. Balke & Mark E. Wohar, 1997. "Nonlinear dynamics and covered interest rate parity," Working Papers 9701, Federal Reserve Bank of Dallas.
    9. repec:ebl:ecbull:v:6:y:2008:i:42:p:1-17 is not listed on IDEAS
    10. Lucio Sarno, 2005. "Viewpoint: Towards a solution to the puzzles in exchange rate economics: where do we stand?," Canadian Journal of Economics, Canadian Economics Association, vol. 38(3), pages 673-708, August.
    11. Jonathan Kearns, 2007. "Commodity Currencies: Why Are Exchange Rate Futures Biased if Commodity Futures Are Not?," The Economic Record, The Economic Society of Australia, vol. 83(260), pages 60-73, 03.
    12. Hochradl, Markus & Wagner, Christian, 2010. "Trading the forward bias: Are there limits to speculation?," Journal of International Money and Finance, Elsevier, vol. 29(3), pages 423-441, April.
    13. Philippe Bacchetta & Eric van Wincoop, 2010. "Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle," American Economic Review, American Economic Association, vol. 100(3), pages 870-904, June.
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