Chapter 2: Attempts to solve major puzzles
The forward bias or UIP puzzle is the most well-known, and also perhaps the most important, anomaly. A complete solution to this might help solve many other puzzles. Most of the literature, therefore, focuses on the UIP puzzle. Only recently have scholars attempted to solve more than one puzzle simultaneously. This chapter follows the literature by closely examining several hypotheses about the cause of the UIP puzzle. No attempt is made to review all such attempts. Rather, the objective is to carefully review those papers that contribute heavily to our synthesis models. This chapter first considers two basic relationships in international finance, namely: (a) the fact that the UIP puzzle amounts to the same thing as the fact that the forward premium or discount is a biased predictor of future changes in the spot rate; and (b) the relationship between a Fama regression and an equation that relates the excess return from carry-trade to the lagged value for the interest rate differential. Then the chapter turns to attempts to solve the UIP puzzle. These are tied up with the idea that a Fama regression has one or more missing variables. The two that have received much attention are: (a) a variable “threshold magnitude” or “risk premium”; and (b) a variable exchange rate prediction error. The early literature concentrated on reasons why exchange rate prediction errors might be persistent and of the same sign. The chapter then turns to more recent attempts to solve the UIP and other puzzles.
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