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The Solution to the Forward-Bias and Related Puzzles

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  • Pippenger, John E
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    The forward-bias puzzle is probably the most important puzzle in international finance. But there is a simple solution. Covered interest parity implies that the forward-bias puzzle is the result of two omitted variables: (1) the future change in the forward exchange rate and (2) the future interest rate differential. As Table 3 shows, at least for my data, the downward bias produced by those two omitted variables completely explains the forward-bias puzzle. Covered interest parity also solves three related 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 qt6br3599r.

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    Date of creation: 01 Apr 2010
    Handle: RePEc:cdl:ucsbec:qt6br3599r
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    1. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
    2. Jon Faust & John H. Rogers, 1999. "Monetary policy's role in exchange rate behavior," International Finance Discussion Papers 652, Board of Governors of the Federal Reserve System (U.S.).
    3. Giorgio Valente & Gene L. Leon & Lucio Sarno, 2006. "Nonlinearity in Deviations From Uncovered Interest Parity; An Explanation of the Forward Bias Puzzle," IMF Working Papers 06/136, .
    4. 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.
    5. 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.
    6. 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.
    7. repec:ebl:ecbull:v:6:y:2008:i:42:p:1-17 is not listed on IDEAS
    8. Frankel, Jeffrey & Poonawala, Jumana, 2009. "The Forward Market in Emerging Currencies: Less Biased Than in Major Currencies," Working Paper Series rwp09-023, Harvard University, John F. Kennedy School of Government.
    9. 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.
    10. Avik Chakraborty & Stephen E. Haynes, 2008. "Econometrics of the Forward Premium Puzzle," Economics Bulletin, AccessEcon, vol. 6(42), pages 1-17.
    11. 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.
    12. 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 129-140, May.
    13. Mark E. Wohar & Nathan S. Balke, 1998. "Nonlinear dynamics and covered interest rate parity," Empirical Economics, Springer, vol. 23(4), pages 535-559.
    14. 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.
    15. 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.
    16. Martin Eichenbaum & Charles L. Evans, 1995. "Some Empirical Evidence on the Effects of Shocks to Monetary Policy on Exchange Rates," The Quarterly Journal of Economics, Oxford University Press, vol. 110(4), pages 975-1009.
    17. Cornell, Bradford, 1977. "Spot rates, forward rates and exchange market efficiency," Journal of Financial Economics, Elsevier, vol. 5(1), pages 55-65, August.
    18. 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.
    19. 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.
    20. 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.
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