Do asymmetric and nonlinear adjustments explain the forward premium anomaly?

This paper explores some of the asymmetries and nonlinearities in an attempt to throw light on the forward premium anomaly, where spot exchange rate returns are typically found to be negatively correlated with the lagged interest rate differential and lead to an apparent rejection of Uncovered Interest Parity (UIP). The approach in this paper is motivated by some recent theoretical literature on the limits to speculation and hysteresis. The paper estimates Logistic Smooth Transition Dynamic Regression (LSTR) models with a variety of transition variables, including the lagged forward premium, monetary and income fundamentals and also variables associated with time varying risk premium, including the conditional variances of some fundamentals. Results are reported for nine different currencies. Many of the estimated LSTR models provide evidence for the existence of an outer regime that is consistent with UIP. Estimation of the standard forward premium regression on observations falling in these regimes across the sample is moderately supportive of UIP holding in the outer regime. A simulation experiment also suggests that an LSTR dgp can produce data consistent with the anomaly. However, parameter estimation issues leads to considerable uncertainty with the estimated transition functions and hence imprecise definitions of regimes. The results are an interesting step in the direction of understanding the nonlinear dimension of the problem without fully resolving the anomaly. (c) 2005 Elsevier Ltd. All rights reserved.