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Explaining FX forward bias

Forward bias in foreign exchange markets means that a positive interest rate differential precedes currency appreciation. It has been an empirical regularity in developed FX markets in recent decades. The forward bias contradicts traditional theory: positive risk-adjusted interest rate differentials are supposed to be offset by expected currency depreciation. An academic paper explains how FX forward bias arises when central banks ‘lean against the wind’ of appreciation through sterilized FX interventions.

Pippenger, John 2017, “Forward Bias, the Failure of Uncovered Interest Parity and Related Puzzles”, Departmental Working Papers, UC Santa Barbara.

The post ties in with SRSV’s lecture on price distortions, particularly the part on government interventions, and SRSV’s lecture on implicit subsidies, particularly the part on foreign exchange.

The below are excerpts from the paper. Emphasis and cursive text have been added. Also, passages with mathematical symbols have been replaced by paraphrasing text for easier reading.

Uncovered interest parity and forward bias

“Uncovered interest rate parity [means that] the expected change in the exchange rate equals the appropriate interest rate differential [with a currency’s expected rate of appreciation offsetting its risk-free interest rate differential].”

“Forward bias…refers to the bias and failure of uncovered interest parity under flexible exchange rates between developed countries where short-term interest rate differentials appear to miss-predict the direction of change in future exchange rates…Under flexible exchange rates [the presumed relations between positive interest rate differentials and local currency depreciation] are systematically negative and often negative and significant.”

“The importance of UIP has prompted many attempts to explain the apparent failure of UIP and forward bias. Two of the most widely cited explanations are risk premiums and the failure of rational expectations.”

“The ‘Carry Trade’ refers to borrowing where international interest rates are ‘low’ and lending where they are ‘high’ without cover, which appears to produce profit with little risk. Those profits suggest that, for at least some trades, expected speculative returns exceed risk premiums.”

“This paper asks the following question: Why is the forward bias so great and the failure of uncovered interest parity so dramatic under flexible exchange rates, but not under other regimes?…Rather than concentrating on risk premiums in the equilibrium condition that risk premiums equal expected speculative returns…[the paper] concentrates on showing how sterilized intervention and liquidity effects produce expected speculative returns. Those expected returns produce forward bias and risk premiums even when expectations are rational.”

How FX interventions create forward bias

“The liquidity effects of open market operations and sterilized ‘leaning against the wind’ can explain the failure of uncovered interest parity and forward bias even when expectations are rational.”

“The most common form of intervention when exchange rates are flexible [is] leaning against the wind. Central banks lean against the wind by selling a currency as its price rises and buying as its price falls…Almost 90% percent of central banks sometimes or always lean against the wind and…40% fully sterilize while only 30% never sterilize.”

“Sterilized leaning against the wind [of appreciation] contributes to [forward bias] when two things happen…

  • Leaning against the wind produces subsequent currency appreciation…‘leaning against the wind’ introduces inertia into changes in exchange rates… an implication of dropping the idea that exchange rates are asset prices…
  • Sterilization produces higher interest rate differential… the result of the fact that sterilized intervention affects short-term interest rates directly, but not the monetary base.”

“When the [domestic central bank] fully sterilizes, its intervention does not affect either the local or the foreign monetary base. But…sales of [local] short-term assets tend to raise [local] short-term interest rates while…purchases of [foreign] short-term assets tend to lower [foreign] interest rates. As a result, when leaning against the wind causes the [local central bank] to sell foreign exchange…full sterilization causes the interest rate differential of domestic versus foreign to rise.”

  • “The…more the [central bank] leans against the wind [the larger the purchase of foreign currency and the larger the incease in the local-currency monetary base]…The resulting change in the monetary base depends on sterilization. The [central bank] sterilizes its intervention by selling…assets like T bills…With complete sterilization, intervention does not affect the monetary base.”
  • “Buying [foreign currency] reduces…holdings of [foreign-currency] deposits at the [foreign central bank]. To restore those deposits to their desired level, the [domestic central bank] sells [foreign] assets…Those sales prevent the intervention from affecting the monetary base in the [foreign currency].

Equilibrium implies that expected speculative returns equal risk premiums. That equilibrium implies that exogenous increases in risk premiums increase equilibrium expected returns by reducing the incentive to speculate. It also implies that exogenous increases in those expected returns increase risk premiums by increasing the incentive to speculate. But that equilibrium condition says nothing about ‘causation’; it only says that the two must be numerically equal…Now, starting with the same initial equilibrium, consider the liquidity effects of an open market operation. Those liquidity effects create expected speculative returns. Those expected returns induce speculators to take uncovered positions. Those uncovered positions create risk premiums.”

Limitations of this explanation

“If the [local central bank] does not sterilize, then the same [intervention] increases the [local] monetary base, which tends to…reduce [local] short-term interest rates…As a result, unsterilized intervention tends to reduce the interest rate differential of domestic versus foreign.”

“Liquidity effects fade with maturity and inflationary effects strengthen.”


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