Foreign Exchange Market Efficiency and Risk Management - Literature review Example

Foreign Exchange Market Efficiency and Risk Management Introduction An efficient market simply refers to a market whereby prices fully depict the available information. In the forex market, efficiency implies the presence of zero correlation in foreign exchange rate changes (Fama 1984, p. 320). Put differently, an efficient forex market is hypothesised to incorporate all information from the past exchange rates in the current exchange rates. According to Levich (1983, p. 49), fluctuations in exchange rates are common in foreign exchange markets, leading 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 tailored contract between two parties to set an exchange rate for a business deal 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 rate fixed by the trading parties is used as a forecaster for the prospective spot exchange rate. In an inefficient forex market, the forward rate is a subjective forecaster of spot exchange rate in the future. It is hypothesised 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 and Sodoikhuu (2012, p. 216) explain, economic analysts are currently undecided on whether the above facts should be interpreted to mean that the forex market is ineffective and hence, they do not reach the same conclusion on whether the forex market is effective or not. This essay critically evaluates the supposition that the forex market is reasonably efficient and the rate of forward exchange is a strong determinant of exchange rate shifts and that the international business needs no additional exchange risk management systems. Efficient forex market and forward rate As explained earlier, a forex market is said to be effective when forward 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) explains, all tests of market efficiency focus on testing joint hypotheses that define 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 are 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 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 conclusion of the project. This amount matches with Arcways’ minimum revenue of £8, 000,000 at an exchange rate of £0.8 per franc. Arcways signs this contract and then agrees in writing with the 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 efficient forex markets, the exchange rate will be equal to £1 per Franc after six months, as long as the parties to the forward contract made rational expectations. However, if the value of the 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 forex market is inefficient for a number of reasons. Evidence against market efficiency Lee and Sodoikhuu (2012, p. 216) refute the theory that the forex marketplace is effective given that logical expectations have not been upheld in the past. If it is assumed that the forex market is effective and that the annual foreign rate of interest in the UK is expected to increase 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) however note that these expectations have not been upheld in the past. According to Lee and Sodoikhuu (2012, p. 216), there have been numerous cases where a rise in foreign interest rates above US rates causes the foreign currency 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, for instance, an investor puts his funds in the short-term government securities in the US during a period when it pays a high interest rate, he or she will make extra returns over time. This calls into question the effectiveness of forex market. Hopper (1994, p. 18) notes that the behaviour of forward rates also presents challenges to the hypothesis of the efficiency of the market. 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 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 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 a forward rate equivalent to the anticipated spot exchange rate 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 sets 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) explains that expectations about future events usually prove incorrect and thus, it is impossible to rule out extra returns in the future. If the future spot exchange rate turns out to be greater than the forward rate, an investor will earn extra returns. Similarly, if the anticipated spot exchange rate turns out to be less than the forward rate, the investor would incur losses. Hence, Hopper (1994, p. 19) notes 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 thus suggests that though extra returns appear randomly in some months, the forex market should be efficient in the long-term. However, this would only happen if the forward price is a neutral estimator of the prospective exchange rate (p. 19). According to Hopper (1994, p. 19) the notion that expectations are correct on average, in the long-term, and that the forex market is efficient can be combined into one idea: that a one month forward price is a fair forecaster 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 price will thus be an efficient forecaster 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) argues that the forward price can be termed as a fair forecaster of the prospective spot exchange rate when expectations are correct on average and foreign exchange markets are efficient. However, Lee and Sodoikhuu (2012, p. 216) note that past data on forward and spot exchange rates cast some doubt on the fact that expectations are correct on average and the market is efficient. This provides evidence that the forward price is not an impartial forecaster of the prospective spot exchange rate. If the forward price was an impartial estimator of one-month-ahead spot exchange rate, the forward price should fluctuate randomly around the one-month-in -advance spot exchange rate. By fluctuating randomly, the forward price would over predict the one-month-ahead spot, and as Lee and Sodoikhuu (2012, p. 216) note, the forward rate does not fluctuate randomly around the one-month-ahead spot exchange rate, but rather, it tends to remain lower than the spot rate for extended periods when the spot rate is increasing and to exceed the spot rate for extended periods if the spot rate is declining. Lee and Sodoikhuu conclude that the forward price is not a good estimator of the prospective spot exchange rate. Given that the forward price is a biased estimator of the prospective spot exchange rate, it can be suggested that the forex market may not be effective 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 unfairness in the forward 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 a statistical problem called peso problem. Some economists argue that the forward price may be a prejudiced forecaster of the prospective spot exchange rate, but the forex market remains efficient. MacDonald and Taylor (1990a, p. 54), note that 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 behaviour 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 the near future, the government of Mexico was going to lower the exchange rate so that the peso would be worth less with reference to the U.S. dollar. In fixing the forward foreign exchange rate, trading parties acted in line with the expectations. They had to take chance that the government was likely to devalue the peso (MacDonald & Taylor 1990a, p. 56). Considering the situation prior to the movements in the fixed exchange rate, and assuming that the changes would take place in a month’s time, investors in an efficient market would have to set the value of the peso while fixing the one-month forward rate to be worth less with reference to the dollar. Therefore, the one-month forward price would be an unfair forecaster of one-month-ahead spot exchange rate until the government makes the changes, even though the market is efficient. Economists thus argue that it would be a mistake to sum up that since the forward price is biased, the forex market must be inefficient. They propose that the forward price is prejudiced merely because investors expect an event to take place that would affect the exchange rate, which has not occurred before. According to MacDonald and Taylor (1990a, p. 56), this kind of statistical problem is known as peso problem. Another explanation relates to the seeming lack of reasonable expectations. MacDonald and Taylor (1990b, p. 91) explain that 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 and Taylor (1990b, p. 95) further note 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. The authors note further that although 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 in 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 (1990b, p. 91). They thus defend the foreign exchange market efficiency hypothesis on this base. The likelihood of time-changing risk premium is another potential explanation for the seeming foreign exchange market inefficiency. Some economists agree that the forward price is an unfair forecaster of the prospective spot exchange rate and thus, extra returns are available in the forex 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 forex market try to mitigate risk, 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 than 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 bill interest rates and tend to be negative when the US Treasury bills interest rates exceed those of the UK Treasury bills. Since interest rates on assets such as the treasury bills in a foreign country move 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) explain that there is no statistical evidence on the presence of time-changing risk premium. Cavaglia, Verschoor and Wolff (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) explain that there is possibility that these phenomena may be present in the forex market, but there lacks conclusive evidence which can be used to sustain the forex market efficiency theory. The lack of uniform agreement on whether the forex market is efficient and whether or not the forward price is an impartial estimator of the prospective 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 the inability to make rational expectations. In addition, they argue that the forward price is a prejudiced forecaster of the prospective spot exchange rate. They therefore suggest that this implies that the forex market is inept. 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 in Mexico to illustrate why the forward rate is a subjective estimator of prospective spot exchange rates but maintain that the forex 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 logical expectations and hence, the foreign market is efficient. There is also an argument on the presence of time-changing risk premium, which explains the existence of market efficiency, though this argument lacks support from statistical evidence. Generally, the existing literature on forex 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. References Cavaglia, S M, Verschoor, W F, Wolff, C C 1994 ‘On the biasedness of forward foreign exchange rates: Irrationality or risk premium.’ Journal of Business, vol. 67, pp. 321–343. Fama, E 1984, ‘Forward and spot exchange rates, Journal of Monetary Economics, vol. 14, no. 3, pp. 319-338. Hakkio, C S 1981, ‘Expectations and the forward exchange rate’, International Economic Review, vol. 22, pp. 663–678. Hopper, G P 1994, ‘Is the foreign exchange market inefficient?’ Business Review, accessed October 17, 2012, http://www.philadelphiafed.org/research-and-data/publications/business-review/1994/brmj94gh.pdf Hsieh, D 1984, ‘Tests of rational expectations and no risk premium in forward exchange markets’, Journal of International Economics, Vol. 17, 173–184. Lee, H & Sodoikhuu, K 2012, ‘Efficiency tests in foreign exchange market’ , International Journal of Economics and Financial Issues, Vol. 2, No. 2, 2012, pp. 216-224. Levich, R M 1983, Empirical studies of exchange rates: Price behaviour, rate determination and market efficiency’, National Bureau of Economic Research, Working Paper No. 1112. Levich, R M 2001, International financial markets, 2nd edition, McGraw-Hil, London. MacDonald, R & Taylor, M P 1990a, ‘The term structure of forward foreign exchange rate premiums’, Manchester School of Economic and Social Studies, vol. 58, pp. 54–65. MacDonald, R & Taylor, M P 1990b, ‘The monetary approach to the exchange rate: rational expectations, long-run equilibrium, and forecasting’, IMF Staff Papers, vol. 40, pp. 89–107. Peel, D A & Pope, P F 1995, ‘Time-varying risk premia and the term structure of forward exchange rates’, Manchester School of Economic and Social Studies, vol. 63, pp. 69–81. Salavatore, D 1993, International economics, MacMillan Publishing Company, New York. Read More