Foreign Exchange Market Efficiency
Introduction
An efficient market simple refers to a market in which prices fully reflect the available information. In the foreign exchange market, efficiency implies the presence of zero correlation in foreign exchange rate changes (Fama, 1984, p. 320). In other words, an efficient foreign exchange market is hypothesized to incorporate all information from the past exchange rates in the current exchange rates. As Levich (1983, p. 49) explained, fluctuations in exchange rate are common in foreign exchange markets which lead to uncertainties in the future exchange rates. In many international trade dealings, a forward contract is used as an instrument for exchange rate risk management. A forward contract refers to a customized agreement between two parties to fix an exchange rate for a business transaction that will take place in the future (Levich, 1983, p. 49). In an efficient foreign exchange market, investors are able to make rational expectations, from which they make predictions. A forward exchange rate fixed by the trading parties is used as a predictor for the spot exchange rate in the future. In an inefficient foreign exchange market, the forward exchange rate is a biased predictor of spot exchange rate in the future. It is hypothesized that unlike in an efficient market, investors in an inefficient foreign exchange market are unable to make rational expectations and that they able to enjoy returns for their investments.
Extensive investigations have been conducted on whether the foreign exchange market is efficient or not. However, as Lee & Sodoikhuu (2012, p. 216) explains, economic analysts are currently undecided on whether the above facts should be interpreted to mean that the foreign exchange market is inefficient and hence, they do not reach the same conclusion on whether the foreign exchange market is efficient or not. This paper critically evaluates the hypothesis that “the foreign exchange market is economically efficient and forward exchange rates are a strong indicator of exchange rate movements and that the international business needs no additional exchange risk management systems.”
Efficient foreign exchange market and forward exchange rate
As explained earlier, a foreign exchange market is said to be efficient when forward exchange rates forecast future spot rates accurately (Levich, 2001, p. 128 ). Investors in such a market will not be able to earn unusual gains without exploiting unavailable information. They will base their decisions on the observable prices and hence ensure efficient allocation of resources. In other words, an efficient market needs to be in equilibrium. As Salavatore, (1993, p. 403) explained, all tests of market efficiency focus on testing joint hypothesis that defines expected returns or market equilibrium prices and the hypothesis that investors in such a market are able to set actual prices to reflect their expected results. When the market is in equilibrium the expected returns in the future and correlated with the actual returns in the future, making it an efficient market. This implies that in an efficient market, the actual returns are correlated around the equilibrium, meaning that the expected returns are zero.
The forward exchange rate, as noted earlier, reflects expected changes in spot exchange rates in the future (Salavatore, 1993, p. 403). For example, if the inflation in the UK is expected to rise by 5% in the next one month, then the UK pound will be expected to decline in value by about 5% relative to the value a US dollar after one month. Taking this into consideration, a forward contract expected to take place after one month will fix the selling price of a pound in exchange for a dollar at 5 percent lower compared to the current price. This is a forward contract and its purpose in international trade is to help in eliminating possible exchange rate risks associated with transactions that will take place in the future.
To illustrate this better, suppose, Arcways, a UK construction company signs a contract with the government of France to build section of a road in France for six months. The Government of France then agrees to pay 10, 000,000 Francs upon completion of the work. This amount is consistent with Arcways minimum revenue of £8, 000,000 at the exchange rate of £0.8 per Franc. Arcways signs this contract and then agrees in writing with a bank of France to fix the exchange rate at £1 per Franc as per their expectations of the spot exchange rate after six months. This forward contract entered into with the bank constitutes a legal agreement and it imposes obligations on both parties. By signing the forward contract, Arcways is guaranteed of an exchange rate of £1 per Franc after six months irrespective of what happens to the spot Franc exchange rate. In an efficient foreign exchange market, the exchange rate will be equal to £1 per Franc after six months, as log as the parties to the forward contract made rational expectations. However, if the value of pound were to appreciate or depreciate after the six months, the market would be termed as inefficient (Salavatore, 1993, p. 403). Some economic analysts have suggested that the foreign exchange market is inefficient for a number of reasons.
Evidence against Market Efficiency
Lee and Sodoikhuu (2012, p. 216) refute the hypothesis that the foreign exchange market is efficient given that rational expectations have not been upheld in the past. Assume the foreign exchange market is efficient and the annual foreign interest rate in UK is expected to rise by x percentage points above the domestic interest rate, the US dollar will then be expected to decline in value at an annual rate of x percent. Lee and Sodoikhuu (2012, p. 216), noted that, however, these expectations have not been upheld in the past. According to Lee and Sodoikhuu (2012, p. 216), there has been numerous cases where a rise in foreign interest rates above US rates the foreign currency tends to rise in value, rather than to fall. At the same time, when the US interest rates rise against a foreign interest rate, the US currency tends to rise rather than fall in comparison with the foreign currency. This implies that if an investor, for instance, puts his funds in the short-term government securities in the US during a period when it pays a high interest rate, he is going to make extra returns over time. This calls into question the efficiency of foreign exchange market.
Hopper (1994, p. 18) noted that the behavior of forward exchange rates also presents challenges to the hypothesis of market efficiency. Suppose it is October 1 and the spot exchange rate is 0.8 pound per US dollar. On October 1, an investor can exchange 0.8 pounds for 1 US dollar. Similarly, the investor can look into a one month forward exchange rate for a business transaction that will take place one month from now. For instance, an investor might be able to buy 1 US dollar in the forward market at 1 pound on October 1. The forward exchange rate is known and agreed to on October 1. One month from then, the investor is obliged to trade 1 pound for 1 US dollar. In an efficient market, the parties to the transaction should be able to set the forward exchange rate equal to what they expect the spot exchange rate to be after one month. Otherwise, the foreign exchange market will be allowing for exploitable profit opportunities (Hopper, 1994, p. 18). For instance, suppose the parties to the transaction set the forward exchange rate at 1 pound per US dollar, but the market set the forward exchange at 0.8 pound per US dollar. Then the market would be allowing for a profitable opportunity. However, if the market had set the forward exchange rate at 1 pound per US dollar, no return would have been possible. Hopper (1994, p. 19) explained that expectations about future events usually prove incorrect and thus, it is impossible to rule out extra returns in the future. If the spot exchange rate in the future turns out to be greater than the forward exchange rate, an investor will earn extra returns. Similarly, if the spot exchange rate in the future turns out to be less than the forward rate, the investor would incur losses. Hence, Hopper (1994, p. 19) explained that as long as the expectations are correct on average, the positive returns, over many months, are going to cancel out with the negative returns. In other words, the average return in the long-term will be zero. Hopper, 1994, p. 18 thus suggested that though extra returns appear randomly in some months, the foreign exchange market should be efficient in the long-term. However, Hopper (1994, p. 19) explained further that this would only happen if the forward exchange rate is an unbiased predictor of the future exchange rate.
According to Hopper (1994, p. 19) the notions that expectations are correct on average, in the long-term, and that the foreign exchange market is efficient can be combined into one idea: that a one month forward exchange rate is an un-unbiased predictor of the spot exchange rate one month ahead. In such a case, the one-month forward rate will be equal on average to the market’s estimation of one-month-ahead spot exchange rate. The forward exchange rate will thus be an efficient predictor of the spot exchange rate in the market. As noted, the forward rate prediction may not be correct for specific months but the average ought to be correct in the long-term. In some months, the forward rate may predict a one-month-ahead spot exchange rate that is too high compared to the actual one-month-ahead spot exchange rate. In other months, the predicted value may be too low. When expectations are correct on average, the high predictions ought to cancel out with the low predictions such that the predictions will be unbiased either on high or low sides. Therefore Hopper (1994, p. 19) argued that the forward exchange rate can be termed as an unbiased predictor of future spot exchange rate when expectations are correct on average and foreign exchange markets are efficient.
However, Lee and Sodoikhuu (2012, p. 216) noted that the past data on spot and forward exchange rates casts some doubt on the fact that expectations are correct on average and the market is efficient. It provides evidence that the forward exchange rate is not an unbiased predictor of the future spot exchange rate. If the forward exchange rate was an unbiased estimator of one-month-ahead spot exchange rate, the forward rate should fluctuate randomly around the one-month-ahead spot exchange rate. By fluctuating randomly, the forward rate would over predict the one-month-ahead spot and Sodoikhuu (2012, p. 216), “the forward exchange rate does not fluctuate randomly around the one-month-ahead spot exchange rate, but rather, it tends to stay below the spot rate for extended periods when the spot rate is rising and to stay above the spot rate for extended periods when the spot rate is declining.” Lee and Sodoikhuu (2012, p. 216) concludes that the forward exchange rate is a biased estimator of the future spot exchange rate. Given that the forward exchange rate is a biased estimator of the future spot exchange rate, it can be suggested that the foreign exchange market may not be efficient and that it is possible to earn extra returns in the long-term. According to Lee and Sodoikhuu (2012, p. 216), however, some economic analysts are not convinced that this is enough proof that the foreign exchange market is inefficient. Consequently, they have come up with explanations that allow for the bias in the forward exchange rate while maintaining market efficiency at the same time.
Explanations for seeming market inefficiency advanced by some economics
Several explanations have been advanced for seeming market inefficiency. One of these explanations is the presence of statistical problem called peso problem. Some economists argue that the forward exchange rate may be a biased predictor of the spot exchange rate in the future, but the foreign exchange market remains efficient. According to MacDonald and Taylor (1990b, p. 54), this can happen when investors expect an event to take place in the future and affect exchange rates, which has not taken place in the past. A good example of such situation is the behavior of the Mexican Peso in 1970s. The government of Mexico used to fix the spot peso-dollar exchange rate at a constant value. However, it was expected that sometimes in near future, the government of Mexico was going to lower the exchange rate so that the peso would be worth less in terms of the U.S dollar. In fixing the forward foreign exchange rate, trading parties acted in line with the expectations. They had o take chance that the government was likely to devalue the peso (MacDonald & Taylor 1990b, p. 56). Consider the situation prior to the changes in the fixed exchange rate, assuming that the changes would take place in a month’s time. Investors in an efficient market will set the value of the peso while fixing the one-month forward rate to be worth less in terms of the dollar. Therefore, the one-month forward rate will be a biased predictor of one-month-ahead spot exchange rate until the government makes the changes, even though the market is efficient. The economists thus argue that it would be a mistake to conclude that since the forward exchange rate is biased, the foreign exchange market must be inefficient. They argue that the forward rate is biased merely because investors expect an event to take place that would affect the exchange rate, that has not occurred before. According to MacDonald & Taylor (1990b, p. 56), this kind of statistical problem is known as peso problem.
A second explanation relates to the seeming lack of rational expectations. MacDonald and Taylor (1990a, p. 91) explained that in the assumption of rational expectations, which pervades both international finance and most branches of economics, seems to be plausible. However, it is difficult to verify the rational expectation, given that it is not easy to directly observe people’s expectations. MacDonald & Taylor (1990a, p. 95) noted that “there is tendency by some researchers and analysts to attack this problem indirectly by using surveys of market expectations to represent the true market expectations.” Consequently, they end up making the wrong conclusion, that the investor’s expectations never follow a systematic pattern. MacDonald & Taylor (1990a, p. 95) argued that though investors make mistakes in estimating future exchange rates, they eventually learn to estimate the average exchanges rates in the future. Precisely, investors have an incentive not to make systematic mistakes I the estimation since this can lead to great losses. They thus learn to make rational expectations. Generally, economists supporting this view agree that the absence of rational expectations can lead to foreign exchange market inefficiency, but they are reluctant to discard the notion of rational expectations given its inherent plausibility (MacDonald & Taylor (1990a, p. 91) They thus defend the foreign exchange market efficiency hypothesis on this base.
The possibility of time-varying risk premium is another potential explanation for the seeming foreign exchange market inefficiency. Some economists agree that the forward exchange rate is a biased predictor of the future spot exchange rate and thus, extra returns are available in the foreign exchange market. However, they argue that the extra returns can simply be termed as compensation for bearing the risk that the investors are exposed to in the market (Peel & Pope, 1995, p. 69). They suggest that investors in the foreign exchange market are risk-averse, meaning that they must be compensated for the risks they are exposed to, given that future exchange rates are uncertain. In other words, investors require a risk premium to compensate them for holding risky investments.
If for instance the UK Treasury bills are judged riskier than the US bills, the UK bills must pay a higher return than the US bills. Conversely, if the US bills are rated to be riskier, they should pay higher returns tan the UK bills. Under the risk premium hypothesis, the return on such investment can either be positive or negative (Peel & Pope, 1995, p. 69). The risk premium on UK Treasury bills tends to be positive when the UK Treasury bills interest rates exceed the US Treasury bills interest rates and tends to be negative when the US Treasury bills interest rates exceed those of UK Treasury bills. Since interest rates on assets such as the treasury bills in a foreign country moves above and below the domestic treasury bills rate, the risk premium varies frequently between positive and negative values. It is for this reason that economic analysts supporting this view talk of time-varying risk premium (Peel & Pope, 1995, p. 69). They conclude that the risk premium is present in every risky market, though the market may be efficient. Therefore, according to these analysts, investors in the foreign exchange market get risk compensation called risk premium, though the market remains efficient. However, Lee and Sodoikhuu (2012, p. 216) explains that there is no statistical evidence on the existence of time-varying risk premium.
Cavaglia et al (1994, p. 44) and Hopper (1994, p. 19) found that the seeming foreign exchange market inefficiency can be explained by the peso problem, the failure of rational expectations or time-varying risk premium. However, Lee and Sodoikhuu (2012, p. 216) explains that there is possibility that these phenomena may be present in the foreign exchange market, but there lacks conclusive evidence which can be used to support foreign exchange market efficiency hypothesis. The lack uniform agreement on whether the foreign exchange market is efficient and whether the forward exchange rate is an unbiased estimator of the future spot rate makes it difficult to conclude whether the international business needs no additional exchange risk management system apart from the forward rate.
Conclusion
In conclusion, there is no satisfactory answer to the question of foreign exchange market efficiency. Various analysts have refuted the hypothesis on foreign exchange market efficiency, suggesting that investors are always able to earn extra returns from investments in other nations, resulting from inability to make rational expectations. In addition, they argue that the forward exchange rate is a biased predictor of future spot exchange rate. They therefore argue that this implies that the foreign exchange market is inefficient. Other economists argue that the aforementioned phenomena are present but they should not be interpreted to mean the existence of foreign exchange market inefficiency. They use the peso problem to explain the reason why the forward exchange rate is a biased predictor of future spot exchange rate but maintain that the foreign exchange market remains efficient. Additionally, they argue that surveys used to show that investors do not have rational expectations do not produce convincing results. According to this group of economists, investors eventually learn to make rational expectation and hence, the foreign exchange market is efficient. There is also an argument on the existence of time-varying risk premium, which explains the existence of market efficiency, though this argument lacks support from statistical evidence. Generally, the existing literature on foreign exchange market efficiency is not conclusive and hence, there is possibility that this market may be efficient or inefficient. This also makes it difficult to conclude whether the international business needs no additional exchange risk management system other than from the forward rate
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