Currency forecasting and market efficiency

Banks and independent consultants offer many currency-forecasting services. Some MNCs have in-house forecasting capabilities. Yet, no one should pay for currency-forecasting services if foreign-exchange markets are perfectly efficient. The efficient market hypothesis holds that: (1) spot rates reflect all current information and adjust quickly to new information; (2) it is impossible for any market analyst to consistently "beat the market"; and (3) all currencies are fairly priced.

Foreign-exchange markets are efficient if the following conditions hold: First, there are many well-informed investors with ample funds for arbitrage opportunities when opportunities present themselves. Second, there are no barriers to the movement of funds from one country to another. Third, transaction costs are negligible. Under these three conditions, exchange rates reflect all available information. Thus, exchange rate changes at a given time must be due to new information alone. Because information that is useful for currency forecasting tends to arrive randomly, exchange rate changes follow a random walk. In other words, no one can consistently beat the market if foreign-exchange markets are efficient. Because all currencies are fairly priced in efficient exchange markets, there are no undervalued currencies and therefore no investors can earn unusually large profits in foreign-exchange markets.

Financial theorists define three forms of market efficiency: (1) weak-form efficiency, (2) semi-strong-form efficiency, and (3) strong-form efficiency. Weak-form efficiency implies that all information contained in past exchange rate movements is fully reflected in current exchange rates. Hence, information about recent trends in a currency's price would not be useful for forecasting exchange rate movements. Semistrong-form efficiency suggests that current exchange rates reflect all publicly available information, thereby making such information useless for forecasting exchange rate movements. Strong-form efficiency indicates that current exchange rates reflect all pertinent information, whether publicly available or privately held. If this form is valid, then even insiders would find it impossible to earn abnormal returns in the exchange market.

Efficiency studies of foreign-exchange markets using statistical tests, various currencies, and different time periods have not provided clear-cut support of the efficient market hypothesis. Nevertheless, all careful studies have concluded that the weak form of the efficient market hypothesis is essentially correct. Empirical tests have also shown that the evidence of the semistrong-form efficiency is mixed. Finally, almost no one believes that strong-form efficiency is valid.

Dufey and Giddy (1978) suggested that currency forecasting can only be consistently useful or profitable if the forecaster meets one of the following four criteria:

1 The forecaster has exclusive use of a superior forecasting model.

2 The forecaster has consistent access to information before other investors.

3 The forecaster exploits small but temporary deviations from equilibrium.

4 The forecaster predicts the nature of government intervention in the foreign-exchange market.

Three methods — fundamental analysis, technical analysis, and market-based forecasts — are widely used to forecast exchange rates. Fundamental analysis relies heavily on economic models. Technical analysis bases predictions solely on historical price information. Market-based forecasts depend on a number of relationships that are presumed to exist between exchange rates and interest rates.

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