On the (in)feasibility of covered interest parity as a solution to the forward bias puzzle

Abstract

This paper examines Pippenger's (2011) proposed solution to the forward bias puzzle, which is based on the covered interest parity (CIP) condition. It is argued that the CIP-based approach does not solve this well known and long-standing puzzle in international finance in a meaningful way. Moreover, it is shown that empirical results from such an approach follow mechanically from the identity-like nature of the theory of covered interest parity, which, aside from small deviations due to transaction costs, is assumed to hold in all periods (as if it were an identity). We show that rather than leading to new insights, the simple reconfiguration of CIP to solve for the time t + 1 spot exchange rate leads to tautological expressions that, when estimated, might appear to successfully explain the forward bias, but in actuality are trivial. Results from simple simulation exercises further illustrate the inconclusiveness of the proposed solution method.