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The Forward-Bias Puzzle: A Solution Based on Covered Interest Parity

  • Pippenger, John
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    When covered interest parity holds, as appears to be the case, the forward exchange rate is not the expected future spot rate. As a result: (1) in general covered and uncovered interest parity are mutually inconsistent; (2) the standard equation that produces the forward-bias puzzle is miss-specified. When covered interest parity is used to correct that miss-specification, the puzzle disappears. Forward premiums are unbiased estimates of future changes in exchange rates. This solution for the forward-bias puzzle holds whether or not there is a risk premium. It also solves two subsidiary puzzles.

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    Paper provided by Department of Economics, UC Santa Barbara in its series University of California at Santa Barbara, Economics Working Paper Series with number qt4dd1075r.

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    Date of creation: 01 Oct 2009
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    Handle: RePEc:cdl:ucsbec:qt4dd1075r
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    1. Clinton, Kevin, 1988. "Transactions Costs and Covered Interest Arbitrage: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 358-70, April.
    2. Lucio Sarno & Giorgio Valente & Hyginus Leon, 2006. "Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle," Review of Finance, European Finance Association, vol. 10(3), pages 443-482, September.
    3. Nathan S. Balke & Mark E. Wohar, 1997. "Nonlinear dynamics and covered interest rate parity," Working Papers 9701, Federal Reserve Bank of Dallas.
    4. Obstfeld, Maurice & Rogoff, Kenneth, 2000. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," Center for International and Development Economics Research, Working Paper Series qt0sx02651, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
    5. Goodhart, Charles A E & McMahon, Patrick C & Ngama, Yerima Lawan, 1992. "Does the Forward Premium/Discount Help to Predict the Future Change in the Exchange Rate?," Scottish Journal of Political Economy, Scottish Economic Society, vol. 39(2), pages 129-40, May.
    6. 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.
    7. Geert Bekaert & Min Wei & Yuhang Xing, 2002. "Uncovered Interest Rate Parity and the Term Structure," NBER Working Papers 8795, National Bureau of Economic Research, Inc.
    8. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2008. "Arbitrage in the foreign exchange market: Turning on the microscope," Journal of International Economics, Elsevier, vol. 76(2), pages 237-253, December.
    9. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
    10. repec:ebl:ecbull:v:6:y:2008:i:42:p:1-17 is not listed on IDEAS
    11. Eichenbaum, Martin & Evans, Charles L, 1995. "Some Empirical Evidence on the Effects of Shocks to Monetary Policy on Exchange Rates," The Quarterly Journal of Economics, MIT Press, vol. 110(4), pages 975-1009, November.
    12. 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.
    13. Lucio Sarno, 2005. "Towards a Solution to the Puzzles in Exchange Rate Economics: Where Do We Stand?," Working Papers wp05-11, Warwick Business School, Finance Group.
    14. 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.
    15. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
    16. Stephen E. Haynes & Avik Chakraborty, 2005. "Econometrics of the forward premium puzzle," University of Oregon Economics Department Working Papers 2005-18, University of Oregon Economics Department.
    17. 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.
    18. Avik Chakraborty & Stephen E. Haynes, 2008. "Econometrics of the Forward Premium Puzzle," Economics Bulletin, AccessEcon, vol. 6(42), pages 1-17.
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