The Efficient Markets Hypothesis - Case Study Example

Running Head: Market efficiency of exchange rates Name: Instructor’s name Institution Subject Date: 30th July 2011 A free market is one that ensures that resources are allocated wisely. An efficient market is expected to allow for the movement of savings into productive investments. It’s a market that leads to tighter bid-ask spreads, higher volumes of trading, and greater market liquidity. In this type of market all information relevant for determining the value of a product is reflected in the current market price. This market ensures the productivity of an investment and secures a high rate of economic growth. In Dr Allan Greenspan’s view these kinds of markets however do not mean that financial analysts and investors can employ fundamental or technical analysis to predict the productivity of an investment in the stock exchange market especially touching on foreign exchange. While conceding the existence of availability of information, Greenspan strongly postulates that any attempts to make profits by exploiting currently available information are futile. To him the use of past information to extrapolate past changes in the future of prices by the use of fundamental or technical methods is no better than the toss of a coin which is totally an event independent of the market system. This, he observed was due a number of factors as follows The efficiency of the markets is such that it’s so hard to predict any future movements in the major currencies with the exception of situations where governments have tried and failed to support a particular exchange rate. To him an efficient market information already contains in itself all that can be known about the future and in that sense has discounted future contingencies as much as is humanly possible. Further trying to discount these changes humanly only leads to errors in their forecasts. Heavy degree of intervention by East Asian monetary authorities, especially in Japan and China, and the apparent stepped up hedging of currency movements by exporters in Europe. This interferes with the efficient market but further throws a spanner in the works of an analyst who could be interested in technical or fundamental analysis to aid in the choice of buying selling or holding foreign exchange for profit. The high purchases by Japan and china are aimed at suppressing the yen dollar exchange rates and their input is to further add into the problem of forecasting the behavior of the exchange rates and the proceeds from trading in them based on their past information. This purchase of dollars so as to protect the country’s exchange rate makes the dollar to soar against even the currencies that are not in the mix of these government interventions. The effect of this interference by governments is to slow or enhance the adjustment process depending on the action of governments. The action of hedging by the foreign exchange traders to safeguard against changes in the foreign exchange rates in the futures market also distorts the earnings that may arise from the trade in the dollar denominated assets. This also helps to slow the adjustment process. Current account balances have a role in the influence of government interventions in the exchange rates and thus fuel the unpredictability. The most sophisticated analytical techniques are unable to profitably project the exchange rates of major currencies because the current account deficit must eventually narrow, the price-adjusted value of the dollar must accordingly decline. The point at which the U.S. current account deficit will be forced to narrow is itself inherently difficult to predict. Those forces that, in the end, are reflected in a current account surplus or deficit are both domestic and foreign and the interventions from both sides will only make it harder for a technical or fundamentalist to arrive at a prediction which captures the eventual true value. In the end the adjustment of a country’s foreign account balance depends on the flexibility of that country’s economy. In domestic economies that approach full flexibility, imbalances are likely to be adjusted well before they become potentially destabilizing. In a similarly flexible world economy, as debt projections rise, product and equity prices, interest rates, and exchange rates could change, presumably to reestablish global balance making the prediction of these variables by a mathematical formula look like the toss of a coin. Lastly protectionist policies to date have aggravated the already complex algorithm of trying to calculate using charts or past economic trends the proceeds from trade in foreign currency. To Greenspan therefore, a manager who relies on technical or fundamental analysis is as weak as a gambler who uses a coin to make decisions. Does the evidence support Dr Alan Greenspan’s comments? Empirical and theoretical findings on this subject are at best divided. Irwin and park (2004) observe that most academics are skeptical about the use of technical or fundamental analysis to arrive at an investment decision. While eluding to the findings of several surveys that technical analysis is significant, his conclusion is that significance doesn’t prove that one could rely on technical analysis to make huge profits from trading in exchange rates. This would seem to lean more to the side of efficient market. Lui and Mole (1998) surveyed the use of technical and fundamental analysis by foreign exchange dealers in Hong Kong in 1995 and found out that dealer’s believed that technical analysis was more useful in forecasting both trends and turning points. Technical analysis appeared to be important to dealers at the shorter time horizons up to 6 months. According to (Fama and Blume, 1966; Jensen and Benington 1970), if the cost of transactions were considered, the returns could even be negative. These results are consistent with the efficient markets hypothesis that technical analysis is without merit. While research has shown that there are positive attributes associated with technical and fundamental analysis, Frankel and Froot (1990) suggested that the overpricing of the US dollar in the 1980s with respect to the underlying economic fundamentals could be due to the impact of technical analysis. Here technical analysis rather than being an aid in investment decision is observed to interfere with the very problem that it sought to solve. More recently, (Lo et al. 2000) examined the prevalence of various technical patterns in American share prices over the period 1962–1996 and found the patterns to be unusually recurrent. The study however does not prove that the patterns are predictable enough to make enough profit to justify the risk, but the authors conclude that this is likely. A survey of dealer s in the foreign exchange markets by (Taylor and Allen 1992 ) found that 90 % of respondents reported the use of some technical analysis , with 60 % stating that they regarded such information as at least as important as economic fundamentals . It is also common for large investment firms to employ technical analysts alongside their fundamental counterpart s (Reilly, 1994). The above literature shows that despite the many years of research on this subject analysts have failed to agree on whether technical analysis is important or not in deciding whether an investment in foreign exchange is profitable or not. Technical analysis of some form is a norm in the financial markets, and consequently, the entire subject of active financial management remains intriguing in the context of market efficiency. This means that a manager is advised to partly rely on technical or fundamental analysis to make investment decisions. References Bisignano, J. (1996, July). VARIETIES OF MONETARY POLICY OPERATING PROCEDURES: BALANCING MONETARY OBJECTIVES WITH MARKET EFFICIENCY. Retrieved July 30, 2011, from BANK FOR INTERNATIONAL SETTLEMENTS: http://www.bis.org/publ/work35.pdf Booth, G. G. (1977). Foreign Exchange Market Efficiency under Flexible Exchange Rates. Journal of Finance. , 32, 1325-30. Greenspan, A. (2011). International Finance 2011. Retrieved July 30, 2011, from Activism: http://www.scribd.com/doc/50440987/Alan-Greenspan-Activism Greenspan, A. (2004). Remarks by Chairman Alan Greenspan . Retrieved July 30, 2011, from The Federal Reserve Board: http://www.federalreserve.gov/boarddocs/speeches/2004/20040302/default.htm Kühl, M. (2007, October). Cointegration in the Foreign Exchange Market and Market Efficiency since the Introduction of the Euro: Evidence based on bivariate Cointegration Analyses. Retrieved July 30, 2011, from http://wwwuser.gwdg.de/~lstohr/cege/Diskussionspapiere/68_Kuehl.pdf Levich, R. M. (n.d.). Empirical Studies of Exchange Rates: Price Behavior, Rate Determinationand Market Efficiency. Retrieved July 30, 2011, from National Bureau of Economic Research: http://www.nber.org/papers/w1112 Ott, K. G. (1987, Dec). Risk Aversion, Efficient Marketsand the Forward Exchange Rate. Retrieved July 30, 2011, from FEDERAL RESERVE BANK OF ST. LOUIS: http://research.stlouisfed.org/publications/review/87/12/Risk_Dec1987.pdf Read More