Forecasting Currency Excess Returns: Can the Forward Bias Be Exploited?

The forward bias anomaly implies that currency excess returns are predictable by the forward premium. Yet, recent studies suggest that statistical inference problems may spuriously account for this predictability. This article demonstrates that while currency excess returns are not predictable out of sample using a standard mean square forecast error criterion, the forward premium nonetheless has directional predictability. This directional forecasting accuracy translates into statistically significant profits from trading on the forward bias anomaly.