Predictability and Mispricing in Emerging vs. Developed Currency Markets

Abstract

In this paper, we study predictability of returns on currencies of emerging and developed economies over the period February 1994 - July 2016. To assess the economic significance of currency predictability, we construct an upper bound on the explanatory power of predictive regressions, motivated by “no good-deal” restrictions that rule out unduly attractive investment opportunities. This bound is an extension of the bound proposed by Ross (2005) in that it allows for imperfect correlation between the kernel and trading strategies that exploit predictability. We find some evidence of predictability of futures returns outside of this bound, for realistic levels of risk aversion, for the emerging markets in our sample. We find, however, no excess-predictability of excessreturns computed from spot exchange rates and spot interest rates, in contrast with the results reported by Hsu et al. (2016) but in agreement with Kuang et al. (2014). The different predictability of spot and futures excess-returns is a noteworthy finding with potentially deep implications for the price discovery mechanism in currency markets. In addition, we find that emerging markets reacted differently from developed market, in terms of informational efficiency, to the onset of the ’post-Lehman’ financial crisis.