MARKET EFFICIENCY Although the previous example had a nonzero effective return differen-

tial, it might still be an efficient market. A market is said to be efficient if prices reflect all available information. In the foreign exchange market, this means that spot and forward exchange rates will quickly adjust to any new information. For instance, an unexpected change in U.S. economic policy that informed observers feel will be inflationary (like an unexpected increase in money supply growth) will lead to an immediate depreciation of the dollar. If markets were inefficient, then prices would not adjust quickly to the new information, and it would be possible for a well-informed investor to make profits consistently from foreign exchange trading that would otherwise be excessive relative to the risk undertaken.

With efficient markets, the forward rate would differ from the expected future spot rate only by a risk premium. If this were not the case, and the forward rate exceeded the expected future spot rate plus a risk premium, an investor could realize certain profits by selling forward currency now, because she or he would be able to buy the currency at a lower price in the future than the forward rate at which the currency will

be sold. Although profits can most certainly be earned from foreign exchange speculation in the real world, it is also true that there are no sure profits. The real world is characterized by uncertainty regarding the

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that the future will bring unexpected events ensures that profits and losses will result from foreign exchange speculation. If an astute investor possessed an ability to forecast exchange rates better than the rest of the market, the profits resulting would be enormous. Foreign exchange forecasting will be discussed in the next section.

Many studies have tested the efficiency of the foreign exchange market. The fact that they have often reached different conclusions regarding the efficiency of the market emphasizes the difficulty involved in using statistics in the social sciences. Such studies have usually investigated whether the forward rate contains all the relevant information regarding the expected future spot rate. They test whether the forward rate alone predicts the future spot rate well or whether additional data will aid in the prediction. If further information adds nothing beyond that already embodied in the forward rate, the market is said to be efficient. On the other hand, if some data are found that would permit a speculator consistently to predict the future spot rate better than can be done using the forward rate (including a risk premium), then this speculator would earn

a consistent profit from foreign exchange speculation, and one could conclude that the market is not efficient. It must be recognized that such tests have their weaknesses. Although a statistical analysis must make use of past data, speculators must actually predict the future. The fact that a researcher could find a forecasting rule that would beat the forward rate in predicting past spot rates is not particularly useful for current speculation and does not rule out market efficiency. The key point is that such a rule was not known during the time the data were actually being generated. So, if a researcher in 2004 claims to have found a way to predict the spot rates observed in 2002 better than the 2002 forward rates, this does not mean that the foreign exchange market in 2002 was necessarily inefficient. Speculators in 2002 did not have the forecasting rule developed in 2004, and thus could not have used such information to outguess the 2002 forward rates consistently.

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could forecast more accurately than the rest of the market, the potential profits would be enormous. An immediate question is: What makes a good forecast? In other words, how should we judge a forecast of the future spot rate?

We can certainly raise objections to rating forecasts on the basis of simple forecast errors. Even though, other things being equal, we should prefer a smaller forecast error to a larger one, in practice other things are not equal. To be successful, a forecast should be on the “correct side” of the forward rate. The “correct side” means that the forecast makes the market participant choose correctly whether to use the forward market or not. For instance, consider the following example:

Current spot rate: f120 5 $1 Current 12-month forward rate: f115 5 $1 Mr. A forecasts: f106 5 $1 Ms. B forecasts: f116 5 $1

Future spot rate realized in 12 months: f113 5 $1

A Japanese firm has a $1 million receipt due in 12 months and uses the forecasts to help decide whether to cover the dollar receivable with a forward contract or wait and sell the dollars in the spot market in 12 months. In terms of forecast errors, Mr. A’s prediction of f106 5 $1 yields an error of 26.2 percent ([106 2 113]/113) against a realized future spot rate of f113. Ms. B’s prediction of f116 5 $1 is much closer to the realized spot rate, with an error of only 2.6 percent ([116 2 113]/ 113). While Ms. B’s forecast is closer to the rate eventually realized, this is not the important feature of a good forecast, in this case. Ms. B forecasts a future spot rate in excess of the forward rate, so if it followed her prediction, the Japanese firm would wait and sell the dollars in the spot market in 12 months (or would take a long position in dollars). Unfortunately, since the future spot rate f113 5 $1 is less than the current forward rate at which the dollars could be sold (f115 5 $1), the firm would receive f113 million rather than f115 million for the $1 million.

Following Mr. A’s forecast of a future spot rate below the forward

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forecasting error is not useful. Corporate treasurers or individual speculators want a forecast that will give them the direction the future spot rate will take relative to the forward rate.

If the foreign exchange market is efficient so that prices reflect all available information, then we may wonder why anyone would pay for forecasts. There is some evidence that advisory services have been able to “beat the forward rate” at certain times. If such services could consistently offer forecasts that are better than the forward rate, what can we conclude about market efficiency? Evidence that some advisory services can consistently beat the forward rate is not necessarily evidence of a lack of market efficiency. If the difference between the forward rate and the forecast represents transaction costs, then there is no abnormal return from using the forecast. Moreover, if the difference is the result of a risk premium, then any returns earned from the forecasts would be a normal compensation for risk bearing. Finally, we must realize that the services are rarely free. Although the economics departments of larger banks sometimes provide free forecasts to corporate customers, professional advisory services charge anywhere from several hundred to many thou- sands of dollars per year for advice. If the potential profits from speculation are reflected in the price of the service, then once again we cannot earn abnormal profits from the forecasts.

Exchange rate forecasters typically use two types of models: technical or fundamental. A fundamental model forecasts exchange rates based on variables that are believed to be important determinants of exchange rates. As we shall learn later in the text, fundamentals-based models of exchange rates view as important things like government monetary and fiscal policy, international trade flows, and political uncertainty. An expected change in some fundamental variable leads to

a current change in the forecast. A technical trading model uses the past history of exchange rates to predict future movements. Technical traders are sometimes called chartists because they use charts or dia- grams depicting the time path of an exchange rate to infer changing trends. Finance scholars typically have taken a dim view of technical

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technical analysis to form their expectations of exchange rates. However, the same surveys suggest that technical models are seen as particularly useful for short-term forecasting, while fundamentals are seen as more important for predicting long-run changes.

Although the returns to a superior forecaster would be considerable, there is no evidence to suggest that abnormally large profits have been produced by following the advice of professional advisory services. But then if you ever developed a method that consistently outperformed other speculators, would you tell anyone else?

MARKET EFFICIENCY Although the previous example had a nonzero effective return differen-