Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle

By Lucio Sarno, Hyginus Leon, Giorgio Valente. Social Science Research Network, 2006

178 citations recorded by the source corpus.

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.

Subfields: Economics and Econometrics

View Paper: https://www.semanticscholar.org/paper/d7dd9b3d843f128c18dbff62463817de7b804b99

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1. Tommaso Mancini-Griffoli
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Citations in the corpus

• Limits to arbitrage during the crisis: funding liquidity constraints and covered interest parity (2011, background): “Because secured arbitrage involves the pledging of collateral, it excludes counterpart Note that technically a risky transaction cannot be called arbitrage, as pointed out in Schleifer (2000). We none-the-less stick to the term “CIP arbitrage” following common practice the literature.”