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