Efficiency of Foreign Exchange Market Coursework

Efficiency of Foreign Exchange Market - Coursework Example In efficient markets, there are opportunities neither for the hedgers nor for the speculators to make super-normal profits (Fama, 1970). In such a situation, speculative efficiency and arbitraging efficiency exist. The speculative efficiency hypothesis is the proposition that says if there is speculative efficiency in the market, the expected rate of return to due speculation in the forward foreign exchange market is zero (Hansen and Hodrick, 1980). The arbitraging efficiency hypothesis is the proposition that the expected rate of return to covered or uncovered interest arbitrage in the international capital market is zero. Interest arbitrage is a form of arbitrage where funds are taken out of home country to invest in a foreign country’s interest bearing securities. This strategy tries to make profit from the difference in interest rate of the two countries. Interest arbitrage is a central concept to understand the foreign exchange movements. Literature Review For testing the speculative efficiency of any foreign exchange market, many academicians consider the hypothesis that the forward price is the best forecast available of future spot price. For the test of arbitraging efficiency, several authors test covered interest parity (CIP), i.e. the parity between the forward discount from the expected spot and the interest differential between a pair of currencies. Since transactions costs and risk premium are there in the price, now it has become a widely known fact that, rejecting the CIP test doesn’t necessarily imply that the market is arbitraging inefficient. In the context of a simple forward market model it can be shown that arbitraging efficiency can exist even if CIP does not hold and transactions costs and risk premium are absent (Stein, 1965). In reality, prices include transaction costs and there is a presence of risk premium for the risk taken by taking position on that particular asset. Since transactions costs and risk premium exist in practice (Bilson, 1981); a departure from CIP does not necessarily imply arbitraging inefficiency. With transactions costs and risk premium, it can be shown that the null hypothesis for testing CIP differs from that for testing arbitraging efficiency. Frequent failures of the tests of market efficiency as the forward discount deviates from either the interest differential or expected depreciation; have led researchers to postulate the existence of a risk premium. There have been also a lot of cases of large difference of average holding returns across asset classes. Moreover the risk premium has been time dependent (Grauer et al, 1976). Researchers have often tested for a risk premium as a function of the variance of forecast errors or of the exchange rate movements (Domowitz and Hakkio, 1985). A usual initiative for researchers while testing for speculative efficiency is that they take for granted that speculators are risk neutral. Empirical studies for a large variety of currenci es and time periods and for the recent floating experience tend to report results which are unfavorable to the efficient market hypothesis under risk neutrality (Longworth, 1981; Fama, 1984). For the period 1973 to 1979, Hansen and Hodrick (1980), using weekly data and three-month forward rates and carrying out tests involving the currencies of seven countries which are Canada, France, Italy,