Foreign Exchange Market Efficiency, Speculators, Arbitrageurs and International Capital Flows

The foreign exchange market efficiency hypothesis is the proposition that prices fully reflect information available to market participants, i.e. hedged interest-arbitrageurs and speculators, and there are no opportunities for the hedgers or the speculators to make super-normal profits, i.e. both speculative efficiency and arbitraging efficiency exist. Numerous previous studies have tested for speculative efficiency and arbitraging efficiency by testing the following two hypotheses respectively: (i) the forward discount is a good predictor of the change in the future spot rate (implying covered interest parity (CIP), uncovered interest parity and rational expectations - all hold) and (ii) the forward discount tends to be equal to the interest differential (implying that CIP holds). It will be shown in this study that the hypotheses (i) and (ii) are valid null hypotheses for speculative efficiency and arbitraging efficiency respectively only if the following two set of assumptions hold: (a) there is no risk premium and no transaction costs and (b) that expectations are unbiased, efficient, firmly held and identical across agents. Thus, underlying the hypotheses (i) and (ii) above is the joint hypothesis that both set of assumptions hold. The rejection of UIP or CIP would simply mean the rejection of this joint hypothesis and not market efficiency. This study also provides a simple rationale for Stein (1965) model in which the fulfilment of covered and uncovered interest parities is unnecessary for foreign exchange market efficiency, even without transaction costs, provided that economic agents hold different expectations concerning exchange and political risks. Using the data on the interest rates and the spot and forward exchange rates for six OECD countries, for the period January 1982-June 1996, this study shows that the forward discount is a very poor predictor of the rate of currency depreciation and that covered interest differential (interest differential minus forward discount) tends to have an opposite sign to and vary inversely with interest differential. These results are inconsistent not only with both the hypotheses of speculative efficiency (based on UIP) and arbitraging efficiency (based on CIP) but also with the Mundell-Flemming proposition concerning capital movements. However, once the role of un-hedged arbitrageurs is recognized, the above results would be perfectly consistent with the Mundell-Flemming proposition. The un-hedged arbitrageurs are speculators who happen to find that they derive greater profit from un-hedged investment in a country of which the interest differential is in favour than from selling that country's currency forward and the condition for the existence of these un-hedged arbitrageurs is that they individually face different transaction costs in their forward exchange dealings. Three reasons for the unexpected relationship between covered and uncovered interest differential are given. The first involves the over-reaction by the government to inflation in fixing the forward discount. The second involves the over-reaction by the speculators to the interest differential in predicting currency depreciation. The third involves the failure of the government to prevent interest rate differential from failing to keep pace with inflation differential. It is argued that the third reason is the most plausible.