Foreign exchange market efficiency and common stochastic trends

Abstract

In a recent paper, Baillie and Bollerslev (1989), using daily data from 1980 to 1985, identified six common stochastic trends in a vector of seven nominal exchange rates implying the existence of one cointegrating vector. Cointegration implies that (Granger) causality must run in at least one direction, that is, at least one of the exchange rates is predictable using current available information. This result has been interpreted as foreign exchange market inefficiency, by many. Another interpretation is suggested if the stationary linear combination of spot rates proxies for a time varying risk premium in some way. Then these results could be explained in a rational and risk averse market. This possibility is eliminated if the time series properties of the risk premium are incompatible with those of the error correction term. Specifically, it is demonstrated that the forward risk premium is non-stationary for the exchange rates that comprise the exchange rate cointegration relationship. In this paper, the existence of common stochastic trends in a vector of nominal exchange rates is tested over the period 1974 to 1991. The efficiency of foreign exchange markets is then tested by examining the implications of stochastic trends in the forward premium and what this means for the time series properties of a time-varying forward risk premium. (JEL F31, G14).