Sarno L., Taylor M.P. The microstructure of the foreign-exchange market: a selective survey of the literature

Princeton studies in international economics №89, May 2001
USA, New Jersey, Princeton University, 2001. – 66 p.This article 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.