Working Paper: CEPR ID: DP5527
Authors: Lucio Sarno; Giorgio Valente; Hyginus Leon
Abstract: We provide empirical evidence that deviations from the uncovered interest rate parity (UIP) condition display significant nonlinearities, consistent with theories based on transactions 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.
Keywords: foreign exchange; forward bias; nonlinearity; uncovered interest parity
JEL Codes: F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Nonlinear DGP (C69) | Rejection of UIP in linear regressions (C29) |
| Nonlinearities in spot and forward rates (E43) | Limits to speculation hypothesis (D84) |
| Deviations from UIP condition (F16) | Significant nonlinearities (C32) |
| Low Sharpe ratios (G19) | Persistence in forward bias (G40) |
| High Sharpe ratios (G19) | Rapid reversion to UIP (L33) |
| Statistical rejections of UIP (C12) | Minor deviations rather than significant market inefficiencies (G14) |