Exchange Rate Market Efficiency: Across and Within Countries
Tammy A. Rapp and Subhash C. Sharma
This paper utilizes cointegration testing and common-feature testing to investigate market efficiency among daily spot and forward exchange rates of the G-7 countries. Efficiency
of the exchange rates was tested across countries and within countries. Across country efficiency was tested for co-movement between spot exchange rates and between forward
exchange rates of different countries. The across-country evidence supports efficiency, as no co-movement was detected. Within-country efficiency was investigated using three
different tests, and the results are mixed. Market efficiency within countries is supported by the finding of co-movement between the forward rate and the corresponding spot rate,
and by the finding of stationarity of the forecast errors. However, the rate of depreciation and the forward premium were not found to exhibit the co-movement that efficiency
would imply.
© 1999 Elsevier Science Inc. Keywords:
Exchange rates; Efficiency; Common feature; Cointegration JEL classification:
F, F3
I. Introduction
There is a growing interest among researchers, currency traders, and politicians as to whether or not the exchange rates are determined efficiently in the markets. The concept
of efficient markets was originated by Fama 1965, who described an efficient market as consisting of a large number of competitive profit maximizers interacting in a market
utilizing all available information in a rational manner. In an efficient market, prices must fully reflect all relevant and available information; hence, no profit opportunities are left
unexploited. If currency markets are efficient, the spot forward exchange rates should embody all relevant information, and it should not be possible to forecast one spot
Department of Economics and Finance, Northeast Louisiana University, Monroe, Louisiana; Department of Economics, Southern Illinois University, Carbondale, Illinois.
Address correspondence to: Dr. T. A. Rapp, College of Business Administration, Department of Economics and Finance, Northeast Louisiana University, Monroe, LA 71209-0130.
Journal of Economics and Business 1999; 51:423– 439 0148-6195 99 –see front matter
© 1999 Elsevier Science Inc., New York, New York PII S0148-61959900017-X
forward exchange rate as a function of another. Also, the current forward rate should be an unbiased predictor of the future spot rate if we assume risk neutrality and a covariance
stationary risk premium. That is, the current forward exchange rate should forecast the future spot rate if the markets are efficient.
To test for exchange rate market efficiency across countries, a number of researchers, such as MacDonald and Taylor 1989, Coleman 1990, Hakkio and Rush 1989,
Copeland 1991, Sephton and Larsen 1991, Baillie and Bollerslev 1994, and Diebold et al. 1994, have applied the concept of cointegration to spot exchange rates. If spot
exchange rates are cointegrated, then the series can be expressed with a causal ordering in at least one direction. Thus, it is hypothesized that if the exchange rates are cointe-
grated, then it is possible to predict one from another, thereby violating the efficient market hypothesis. Depending on the time period, selection of exchange rates, and
methodology utilized, these researchers have differed in their rejection of the Efficient Market Hypothesis EMH for spot exchange rates. Similarly, Baillie and Bollerslev
1989 and Hakkio and Rush 1989 investigated market efficiency across countries among forward exchange rates by applying the concepts of bivariate and multivariate
cointegration.
Exchange rate efficiency can also be tested within a single country by testing for co-movement between a single country’s spot and forward exchange rates. Studies
utilizing cointegration to investigate exchange rate efficiency within a country include Baillie and Bollerslev 1989, Hakkio and Rush 1989, and Crowder 1994. Generally,
the results have supported market efficiency within the countries studied.
This study investigates the efficiency of the spot and forward exchange rates markets across countries and within countries. To test for market efficiency across countries, the
daily spot exchange rates and one-month forward exchange rates, with respect to the U.S. dollar, from June 1, 1973 through December 31, 1996 for the Group of Seven countries
i.e., United States, Germany, Italy, Japan, the United Kingdom, France, and Canada were utilized. Cointegration testing within the context of bivariate models were utilized
for spot and for forward exchange rates to determine whether a long-run relationship between the spot exchange rates or between the forward exchange rates exists. If a
long-run relationship exists, this would violate the EMH, as one spot forward exchange rate could be predicted as a function of another spot forward exchange rate. For bivariate
pairs not found to have a cointegrating relation, common feature tests were used in order to analyze stationary co-movement between exchange rates. A common serial correlation
feature between spot exchange rates or between forward exchange rates would indicate market inefficiency.
To test for market efficiency within the individual countries, the same data were utilized as for the efficiency tests across countries except, in this analysis, we took the spot
and forward exchange rate of a single country, and investigated co-movement between the two rates. For the within-country efficiency tests there were a total of three tests
performed. The forward rate should be an unbiased predictor of the future spot rate. Therefore, a spot and forward rate of the same country should exhibit co-movement. The
first test investigated the existence of this predicted co-movement through the use of cointegration. The finding of a cointegrating vector would support market efficiency in
this case. If no cointegrating vector is found, then common feature analysis could be utilized to test for stationary co-movement between the variables. To support market
efficiency in this unbiased predictor hypothesis of the forward rate and spot rate, some co-movement, either nonstationary or stationary, needs to be ascertained. The second test
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T. A. Rapp and S. C. Sharma
for co-movement tested for the existence of a unit root in the forecast error. If the forecast error is nonstationary, then this would imply market inefficiency. The third test was a new
application of the common feature test, as proposed by Engle and Kozicki 1993, and tested for co-movement between the rate of depreciation and the forward premium. If the
markets are efficiently determined, than a common feature should exist between the rate of depreciation and the forward premium.
This study has several distinct features. First, we performed a variety of tests to investigate exchange rate efficiency across countries and within countries. Across coun-
tries, we investigated co-movement between the spot exchange rate of different countries and between forward exchange rates of different countries. Within countries, we per-
formed three sets of tests to ascertain the existence of efficiency between forward exchange rates and the corresponding future spot rate for a single country. Second, we
investigated both the daily spot and forward exchange rates for a large number of countries, and for an extended time period. Third, we allowed for nonstationarity of the
data in our analysis. Fourth, we utilized a new methodology to test for the stationary co-movement between variables which did not have nonstationary co-movement, as
indicated by the cointegration tests. This test, called common serial correlation feature test, allowed us to extend our test of inefficiency across countries where exchange rates
may not reject efficiency due to the lack of a cointegrating vector. This test extended our test of efficiency within countries where a lack of a cointegrating vector would imply
inefficiency but the data may actually contain stationary co-movement. Common feature testing also extended our test of efficiency across countries by investigating co-movement
between the forward premium and the rate of depreciation.
The paper is organized as follows. Section II presents the methodology utilized. Section III provides the empirical results and interpretation. Section IV concludes.
II. Methodology
