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

Abstract

Nonlinearity in Deviations from Uncovered Interest Parity: AnExplanation of the Forward Bias Puzzle*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.JEL Classification: F31

Risk-premia, carry-trade dynamics, and economic value of currency speculation

“…Within this range, traders do not produce order-flow aimed at exploiting the forward bias which, as a consequence, remains persistent. Empirical research suggests that bilateral exchange rates are characterized by a statistically persistent but economically small forward bias, see Sarno et al (2006), thus being in line with the general idea of limits to speculation. However, Della Corte et al (2008) show that dynamic multi-currency strategies yield large economic gains which is consistent with the widespread use of forward bias strategies among market professionals.…”

“…Inspired by the concept of limits to speculation, Sarno et al (2006) investigate the relationship between spot and forward rates in a smooth transition regression framework. They report evidence for such a non-linear relationship, allowing for a time-varying forward bias.…”

“…If profits are statistically different from zero, we judge the economic significance of resulting Sharpe ratios via trader inaction ranges implied by limits to speculation. We provide a formalization of the idea verbally described by Lyons (2001) which also goes beyond the analysis of Sarno et al (2006), as we derive trader inaction ranges analytically. This does not only allow us to empirically test the predictions of the limits to speculation hypothesis that currency speculation should not generate economic value, but also to analyze the dynamics of currency speculation and their linkage to risk-premia.…”

“…We use the standard definition of excess returns given by the difference between the exchange rate return and the lagged premium, see e.g. Bilson (1981), Fama (1984), and Backus et al (1993), Sarno et al (2006)…”

Forward Unbiasedness in the Short End of the Interest Rate Market

“…However, lately the literature has shifted to two new specifications for the risk premium to explain the bias. One specification is non-linearities in the deviation from Uncovered Interest Parity 1 (UIP) (Sarno et al, 2006), or the presence of endogenous structural breaks (Hatemi-J and Roca, 2012), or the parting of the variables between permanent and transitory components (Al-Zouby, 2010). Another approach is to test a joint hypothesis whereby the contemporaneous spot rate is cointegrated with the forward rate, and the other whether the forward rate is an optimal predictor of t he future spot rate.…”