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

Authors
  • Pippenger, John
Publication Date
Oct 01, 2009
Source
eScholarship - University of California
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License
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Abstract

When covered interest parity holds, as appears to be the case, the forward exchange rate is not the expected future spot rate. As a result: (1) in general covered and uncovered interest parity are mutually inconsistent; (2) the standard equation that produces the forward-bias puzzle is miss-specified. When covered interest parity is used to correct that miss-specification, the puzzle disappears. Forward premiums are unbiased estimates of future changes in exchange rates. This solution for the forward-bias puzzle holds whether or not there is a risk premium. It also solves two subsidiary puzzles.

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