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Re-Interpreting the Failure of Foreign Exchange Market Efficiency Tests: Small Transaction Costs, Big Hysteresis Bands

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  • Baldwin, Richard

Abstract

Small transaction costs and uncertainty imply that optimal cross-currency interest rate speculation is marked by a first-order hysteresis band. Consequently uncovered interest parity does not hold and market-efficiency tests based on it are mis-specified. Indeed, measured prediction errors are a combination of true prediction errors and a wedge that consists of the 'option value' of being in foreign currency and either plus or minus the transaction cost. Due to the nature of this wedge, we should expect measured prediction errors to be serially correlated, correlated with the current forward rate and perhaps have a non-zero mean, if the interest differential itself is serially correlated. The existence of the wedge helps account both for the failure of market-efficiency tests and for the difficulties in finding an empirically successful model of the risk premium.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 407.

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Date of creation: Apr 1990
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Handle: RePEc:cpr:ceprdp:407

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Keywords: Foreign Exchange Market Efficiency; Forward Rate Bias; Hysteresis; Risk Premia; Transaction Costs;

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References

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Citations

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Cited by:
  1. David W.R. Gruen & Marianne C. Gizycki, 1993. "Explaining Forward Discount Bias: Is it Anchoring?," RBA Research Discussion Papers rdp9307, Reserve Bank of Australia.
  2. Li, Dandan & Ghoshray, Atanu & Morley, Bruce, 2013. "An empirical study of nonlinear adjustment in the UIP model using a smooth transition regression model," International Review of Financial Analysis, Elsevier, vol. 30(C), pages 109-120.
  3. Huisman, Ronald & Koedijk, Kees & Kool, Clemens & Nissen, Francois, 1998. "Extreme support for uncovered interest parity," Journal of International Money and Finance, Elsevier, vol. 17(1), pages 211-228, February.
  4. Philippe Bacchetta & Eric van Wincoop, 2006. "Incomplete information processing: a solution to the forward discount puzzle," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  5. Bond, Derek & Harrison, Michael J & Hession, Niall & O’Brien, Edward J., 2006. "Some Empirical Observations on the Forward Exchange Rate Anomaly," Research Technical Papers 3/RT/06, Central Bank of Ireland.
  6. Philippe Bacchetta & Eric van Wincoop, 2005. "Rational Inattention: A Solution to the Forward Discount Puzzle," FAME Research Paper Series rp156, International Center for Financial Asset Management and Engineering.
  7. Wagner, Christian, 2012. "Risk-premia, carry-trade dynamics, and economic value of currency speculation," Journal of International Money and Finance, Elsevier, vol. 31(5), pages 1195-1219.
  8. Omer, Muhammad & de Haan, Jakob & Scholtens, Bert, 2013. "Does Uncovered Interest rate Parity Hold After All?," MPRA Paper 47572, University Library of Munich, Germany.
  9. Giorgio Valente & H. L. Leon & Lucio Sarno, 2006. "Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle," IMF Working Papers 06/136, International Monetary Fund.
  10. Pasricha, Gurnain Kaur, 2006. "Survey of Literature on Covered and Uncovered Interest Parities," MPRA Paper 22737, University Library of Munich, Germany.
  11. David W.R. Gruen & Gordon D. Menzies, 1991. "The Failure of Uncovered Interest Parity: Is it Near-rationality in the Foreign Exchange Market?," RBA Research Discussion Papers rdp9103, Reserve Bank of Australia.
  12. Baillie, Richard T. & Kilic, Rehim, 2006. "Do asymmetric and nonlinear adjustments explain the forward premium anomaly?," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 22-47, February.
  13. Kees Koedijk & Clemens Kool, 1993. "Betting on the EMS," Open Economies Review, Springer, vol. 4(2), pages 151-173, June.
  14. McMillan, David G., 2009. "Forward interest rate premium and asymmetric adjustment: Evidence from 16 countries," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 19(2), pages 258-273, April.

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