Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation 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.This paper was partly written while Lucio Sarno was a Visiting Scholar at the International Monetary Fund. Financial support from the Economic and Social Research Council (Grant No. RES-000-22-0404) is gratefully acknowledged. The authors are indebted for useful conversations or constructive comments to Josef Zechner (editor), three anonymous referees, Ulf Axelson, Magnus Dahlquist, Paul De Grauwe, Hans Dewachter, John Driffill, Bob Flood, Gordon Gemmill, Campbell Harvey, Peter Kenen, Rich Lyons, Angelo Melino, Chris Neely, Anthony Neuberger, Carol Osler, David Peel, Dagfinn Rime, Piet Sercu, Per Str?mberg, Shinji Takagi, Gabriel Talmain, Mark Taylor, Timo Ter?svirta, Dan Thornton, Shang-Jin Wei, Mike Wickens and Mark Wohar, as well as to participants at the 2005 European Finance Association Annual Conference, Moscow; 2004 Society of Nonlinear Dynamics and Econometrics Annual Conference, Federal Reserve Bank of Atlanta; the 2004 European Financial Management Association Conference, Basel; and seminars at the International Monetary Fund, Swedish Institute for Financial Research, Central Bank of Norway, University of Oxford, Catholic University of Leuven, University ofWarwick, Chinese University of Hong Kong, York University, University of Exeter, University of Kent, and University of Edinburgh. The authors alone are responsible for any errors that may remain and for the views expressed in the paper.