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FX Dynamics, Limited Participation, and the Forward Bias Anomaly

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  • O. Miguel Villanueva

Abstract

Standard foreign exchange (FX) models with goods price stickiness and instantaneous asset market adjustments imply FX overshooting (Dornbusch, 1976), which can explain the forward bias anomaly. Lyons (2001) explained the anomaly via limited participation of FX speculators due to Sharpe ratios lower than equity market alternatives, which implies FX undershooting to interest differential shocks. I derive the time‐series implications of overshooting and undershooting for the joint forward/spot FX dynamics in a vector error correction model. I use generalized impulse response analysis (Pesaran and Shin, 1998) to test those implications. All FX studied (pound, deutsch mark, French franc, yen, and Canadian dollar) have dynamics consistent with undershooting during the period from 1975 to 1998.

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  • O. Miguel Villanueva, 2005. "FX Dynamics, Limited Participation, and the Forward Bias Anomaly," The Financial Review, Eastern Finance Association, vol. 40(1), pages 67-93, February.
    • Handle: RePEc:bla:finrev:v:40:y:2005:i:1:p:67-93
    DOI: 10.1111/j.0732-8516.2005.00093.x
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    Cited by:

    1. Peijie Wang, 2010. "Assessment on Valuation of RMB – a triangular analysis approach," Working Papers 2010-FIN-02, IESEG School of Management.
    2. Raj Aggarwal & Sijing Zong, 2008. "Behavioral Biases in Forward Rates as Forecasts of Future Exchange Rates: Evidence of Systematic Pessimism and Under-Reaction," Multinational Finance Journal, Multinational Finance Journal, vol. 12(3-4), pages 241-277, September.
    3. Alper, C. Emre & Ardic, Oya Pinar & Fendoglu, Salih, 2007. "The Economics of Uncovered Interest Parity Condition for Emerging Markets: A Survey," MPRA Paper 4079, University Library of Munich, Germany.
    4. C. Emre Alper & Oya Pinar Ardic & Salih Fendoglu, 2009. "The Economics Of The Uncovered Interest Parity Condition For Emerging Markets," Journal of Economic Surveys, Wiley Blackwell, vol. 23(1), pages 115-138, February.
    5. Sercu, Piet & Vandebroek, Martina & Wu, Xueping, 2008. "Is the forward bias economically small? Evidence from European rates," Journal of International Money and Finance, Elsevier, vol. 27(8), pages 1284-1302, December.
    6. Chinn, Menzie D., 2006. "The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 7-21, February.

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