Foreign Exchange Market Efficiency

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In his second review article on efficient capital markets, Fama [49] writes,

"I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information."

He goes on to say,

". . . , market efficiency per se is not testable. It must be tested jointly with some model of equilibrium, an asset-pricing model."

Market efficiency does not mean that asset returns are serially un-correlated, nor does it mean that the financial markets present zero expected profits. The crux of market efficiency is that there are no unexploited excess profit opportunities. What is considered to be excessive depends on the model of market equilibrium.

This chapter is an introduction to the economics of foreign exchange market efficiency. We begin with an evaluation of the simplest model of international currency and money-market equilibrium—uncovered interest parity. Econometric analyses show that it is strongly rejected by the data. The ensuing challenge is then to understand why uncovered interest parity fails.

We cover three possible explanations. The first is that the forward foreign exchange rate contains a risk premium. This argument is developed using the Lucas model of chapter 4. The second explanation is that the true underlying structure of the economy is subject to change occasionally but economic agents only learn about these structural changes over time. During this transitional learning period in which market participants have an incomplete understanding of the economy and make systematic prediction errors even though they are behaving rationally. This is called the 'peso-problem' approach. The third explanation is that some market participants are actually irrational in the sense that they believe that the value of an asset depends on extraneous information in addition to the economic fundamentals. The individuals who take actions based on these pseudo signals are called 'noise' traders.

The notational convention followed in this chapter is to let upper case letters denote variables in levels and lower case letters denote their logarithms, with the exception of interest rates, which are always denoted in lower case. As usual, stars are used to denote foreign country variables.

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