A COMPLETE SOLUTION TO THE FORWARD-BIAS PUZZLE

A complete solution to the forward-bias puzzle should provide an econometric solution and an economic explanation for that solution. A complete solution should also explain the closely related failure of uncovered interest parity. In addition it should explain some related anomalies. One such anomaly is that variances for changes in exchange rates are over 100 times larger than variances for interest rate differentials and forward premiums. My econometric solution is that the relevant test equations omit two variables that covered interest parity implies should be included. For my data, the missing variables explain the failure of uncovered interest parity and the forward-bias puzzle. The missing variables also explain why the variance for changes in exchange rates is over 100 times larger than the variance for both interest rate differentials and forward premiums. My economic explanation is that, in general, forward rates do not equal expected future spot rates.