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The Forward-Bias Puzzle: A Solution Based on Covered Interest Parity

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  • Pippenger, John E

Abstract

The forward-bias puzzle is probably the most important puzzle in international macroeconomics. After more than 20 years, there is no accepted solution. My solution is based on covered interest parity (CIP). CIP implies: (1) Forward rates are not rational expectations of future spot rates. Those expectations depend on future spot rates and interest rate differentials. (2) The forward bias is the result of a specification error, replacing future forward exchange rates with current forward exchange rates. That misspecification is the direct result of (1). Implication (1) has the further implication that, in general, covered and uncovered interest parity are inconsistent.

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  • Pippenger, John E, 2009. "The Forward-Bias Puzzle: A Solution Based on Covered Interest Parity," University of California at Santa Barbara, Economics Working Paper Series qt05d0t24b, Department of Economics, UC Santa Barbara.
    • Handle: RePEc:cdl:ucsbec:qt05d0t24b
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    References listed on IDEAS

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    1. Lucio Sarno & Giorgio Valente & Hyginus Leon, 2006. "Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle," Review of Finance, European Finance Association, vol. 10(3), pages 443-482, September.
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    11. Bekaert, Geert & Wei, Min & Xing, Yuhang, 2007. "Uncovered interest rate parity and the term structure," Journal of International Money and Finance, Elsevier, vol. 26(6), pages 1038-1069, October.
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