The forward premium anomaly is not as bad as you think

The forward premium anomaly refers to the widespread empirical finding that the slope coefficient in the regression of the change in the logarithm of the spot exchange rate on the forward premium is invariably less than unity , and often negative. This "anomaly" implies the apparent predictability of excess returns over uncovered interest rate parity (UIP), and is conventio nally viewed as evidence of a biased forward rate and/or of evidence of a t ime-varying risk premium. This paper presents a stylized model that imposes UIP and allows the daily spot exchange rate to possess very persistent vol atility. The model is calibrated around realistic parameter values for dail y returns and the slope coefficient estimates in the anomalous regressions with monthly data are found to be centered around unity, but are very widel y dispersed, and converge to the true value of unity at a very slow rate. T his theoretical evidence is shown to be consistent with the empirical findi ngs for the monthly sample sizes typically employed in the literature, Henc e, the celebrated unbiasedness regression does not appear to provide as muc h evidence as previously supposed concerning the possible bias of the forwa rd rate. (C) 2000 Elsevier Science Ltd, All rights reserved. JEL classifica tion: C22; F31.