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

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Richard E. Baldwin

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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 miaspecified. 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 the difficulties in finding an empirically successful model of the risk premium.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3319.

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Date of creation: Apr 1990
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Handle: RePEc:nbr:nberwo:3319

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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.:
  1. Longworth, David, 1981. "Testing the Efficiency of the Canadian-U.S. Exchange Market under the Assumption of no Risk Premium," Journal of Finance, American Finance Association, vol. 36(1), pages 43-49, March. [Downloadable!] (restricted)
  2. Frank McCormick, 1979. "Covered-interest arbitrage: unexploited profits: comment," International Finance Discussion Papers 132, Board of Governors of the Federal Reserve System (U.S.).
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  5. Bentolila, Samuel & Bertola, Giuseppe, 1990. "Firing Costs and Labour Demand: How Bad Is Eurosclerosis?," Review of Economic Studies, Blackwell Publishing, vol. 57(3), pages 381-402, July. [Downloadable!] (restricted)
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  7. Frankel, Jeffrey A., 1982. "In search of the exchange risk premium: A six-currency test assuming mean-variance optimization," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 255-274, January. [Downloadable!] (restricted)
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  9. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, vol. 19(1-2), pages 47-66, August. [Downloadable!] (restricted)
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  22. McCormick, Frank, 1979. "Covered Interest Arbitrage: Unexploited Profits? Comment," Journal of Political Economy, University of Chicago Press, vol. 87(2), pages 411-17, April. [Downloadable!] (restricted)
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  28. Rogoff, Kenneth, 1984. "On the effects of sterilized intervention : An analysis of weekly data," Journal of Monetary Economics, Elsevier, vol. 14(2), pages 133-150, September. [Downloadable!] (restricted)
  29. Engel, Charles M., 1984. "Testing for the absence of expected real profits from forward market speculation," Journal of International Economics, Elsevier, vol. 17(3-4), pages 299-308, November. [Downloadable!] (restricted)
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  1. 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 & Financial Services Authority of Ireland (CBFSAI). [Downloadable!]
    Other versions:
  2. Fernando Fernández-Rodríguez & Simón Sosvilla-Rivero & Julián Andrada-Félix, . "Nearest-Neighbour Predictions in Foreign Exchange Markets," Working Papers 2002-05, FEDEA. [Downloadable!]
  3. Philippe Bacchetta & Eric van Wincoop, 2006. "Incomplete information processing: a solution to the forward discount puzzle," Working Paper Series 2006-35, Federal Reserve Bank of San Francisco. [Downloadable!]
    Other versions:
  4. Lucio Sarno & Giorgio Valente & H. L. Leon, 2006. "Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle," IMF Working Papers 06/136, International Monetary Fund. [Downloadable!]
    Other versions:
  5. Kees Koedijk & Clemens Kool, 1993. "Betting on the EMS," Open Economies Review, Springer, vol. 4(2), pages 151-173, June. [Downloadable!] (restricted)
  6. David Gruen & Marianne Gizycki, 1993. "Explaining Forward Discount Bias: Is it Anchoring?," RBA Research Discussion Papers rdp9307, Reserve Bank of Australia. [Downloadable!]
  7. David WR 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. [Downloadable!]
  8. Bacchetta, Philippe & van Wincoop, Eric, 2005. "Rational Inattention: A Solution to the Forward Discount Puzzle," CEPR Discussion Papers 5261, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
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