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What drives currency predictability?

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  • Potì, Valerio
  • Siddique, Akhtar

Abstract

In this paper, we study predictability of exchange rates and explore determinants of its dynamics over time. We model the admissible amount of predictability in two ways, each corresponding in a stylized manner to a broad class of rational currency pricing models, namely those under which the marginal currency trader can diversify away currency risk and alternative specifications under which this possibility is precluded. Under the null of Rational Expectations, we find strong evidence against the former class of models but little evidence against the latter, except that predictability itself is predictable. Our results pose a challenge to Fama's (1970) Efficient Market Hypothesis, but are consistent with microstructure models of foreign exchange markets in which a capital-constrained undiversified marginal currency trader seeks reward for total risk instead of systematic risk alone and sluggish risk-capital mobility drives predictable time-variation in currency predictability.

Suggested Citation

  • Potì, Valerio & Siddique, Akhtar, 2013. "What drives currency predictability?," Journal of International Money and Finance, Elsevier, vol. 36(C), pages 86-106.
  • Handle: RePEc:eee:jimfin:v:36:y:2013:i:c:p:86-106
    DOI: 10.1016/j.jimonfin.2013.03.004
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    Cited by:

    1. Bulkley, George & Harris, Richard D.F. & Nawosah, Vivekanand, 2015. "Can behavioral biases explain the rejections of the expectation hypothesis of the term structure of interest rates?," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 179-193.
    2. Potì, Valerio & Levich, Richard M. & Pattitoni, Pierpaolo & Cucurachi, Paolo, 2014. "Predictability, trading rule profitability and learning in currency markets," International Review of Financial Analysis, Elsevier, vol. 33(C), pages 117-129.
    3. Levich, Richard M. & Potì, Valerio, 2015. "Predictability and ‘good deals’ in currency markets," International Journal of Forecasting, Elsevier, vol. 31(2), pages 454-472.
    4. repec:eee:ecolet:v:162:y:2018:i:c:p:140-145 is not listed on IDEAS
    5. Petros Messis & Achilleas Zapranis, 2014. "Herding behaviour and volatility in the Athens Stock Exchange," Journal of Risk Finance, Emerald Group Publishing, vol. 15(5), pages 572-590, November.

    More about this item

    Keywords

    Foreign exchange; Predictability; Market efficiency;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange

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