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Nonstationarity of efficient finance markets: FX market evolution from stability to instability

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  • McCauley, Joseph L.
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    Abstract

    Real financial markets are uncertain on the shortest trading time scales, therefore trading translates into noise. We discuss the pair correlations of detrended returns necessary to understand financial markets. Efficient markets and equilibrium markets generate conflicting pair correlations. B. Eichengreen [B. Eichengreen, Globalizing Capital,: A History of the International Monetary System, Princeton, Princeton, 1998] argues that FX speculation was stabilizing before WWI. In contrast, our recent empirical analysis shows that we can model FX markets in our present era as nonstationary/unstable and efficient (meaning hard or impossible to beat). We can model pre-WWI non-efficient equilibrium FX dynamics from a closely related theoretical standpoint. Our main points are that deregulated markets are described by a nonstationary process with uncorrelated, nonstationary increments, and that a stationary market (equilibrium market) is mutually exclusive with an unregulated, efficient market. In short, stability and deregulation are mutually exclusive ideas. We review a simple, empirically deduced model of the unstable diffusive nature of volatile FX market dynamics. All information of interest is encoded in the variable diffusion coefficient defining the observed martingale process.

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    Bibliographic Info

    Article provided by Elsevier in its journal International Review of Financial Analysis.

    Volume (Year): 17 (2008)
    Issue (Month): 5 (December)
    Pages: 820-837

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    Handle: RePEc:eee:finana:v:17:y:2008:i:5:p:820-837

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    Web page: http://www.elsevier.com/locate/inca/620166

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    Keywords: Efficient markets Stationary process Nonstationary process Martingale Market instability Gold standard Regulation;

    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. McCauley, Joseph L. & Bassler, Kevin E. & Gunaratne, Gemunu H., 2008. "Martingales, detrending data, and the efficient market hypothesis," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 387(1), pages 202-216.
    2. Bassler, Kevin E. & McCauley, Joseph L. & Gunaratne, Gemunu H., 2006. "Nonstationary increments, scaling distributions, and variable diffusion processes in financial markets," MPRA Paper 2126, University Library of Munich, Germany.
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    Cited by:
    1. Al-Khazali, Osamah M. & Leduc, Guillaume & Pyun, Chong Soo, 2011. "Market efficiency of floating exchange rate systems: Some evidence from Pacific-Asian countries," Global Finance Journal, Elsevier, vol. 22(2), pages 154-168.
    2. McCauley, Joseph L., 2008. "Time vs. ensemble averages for nonstationary time series," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 387(22), pages 5518-5522.

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