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FX Dynamics, Limited Participation, and the Forward Bias Anomaly
Author(s) -
Villanueva O. Miguel
Publication year - 2005
Publication title -
financial review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.621
H-Index - 47
eISSN - 1540-6288
pISSN - 0732-8516
DOI - 10.1111/j.0732-8516.2005.00093.x
Subject(s) - economics , econometrics , speculation , anomaly (physics) , equity (law) , liberian dollar , impulse response , financial economics , monetary economics , mathematics , macroeconomics , physics , mathematical analysis , finance , political science , law , condensed matter physics
Standard foreign exchange (FX) models with goods price stickiness and instantaneous asset market adjustments imply FX overshooting (Dornbusch, 1976), which can explain the forward bias anomaly. Lyons (2001) explained the anomaly via limited participation of FX speculators due to Sharpe ratios lower than equity market alternatives, which implies FX undershooting to interest differential shocks. I derive the time‐series implications of overshooting and undershooting for the joint forward/spot FX dynamics in a vector error correction model. I use generalized impulse response analysis (Pesaran and Shin, 1998) to test those implications. All FX studied (pound, deutsch mark, French franc, yen, and Canadian dollar) have dynamics consistent with undershooting during the period from 1975 to 1998.