The concept of market efficiency
The concept of market efficiency was initially developed for the stock market, but it is equally valid for the foreign exchange market and indeed for markets in general, financial or otherwise.In an efficient market, prices reflect all available information (hence, this is a definition of informational efficiency rather than allocative efficiency).The implication of this definition is that it is not possible to predict price movements from available information because this information is already reflected in prices.Since the arrival of information is random and given that new information is reflected in prices very quickly, the period-to-period changes in prices tend to be random.Another implication is that it is not possible to earn abnormal returns via active trading as compared to what can be obtained from a passive buy-and-hold strategy.
Covered arbitrage is based on information pertaining to interest and exchange rate that is available at the time the decision to indulge in arbitrage is taken.If there are profitable arbitrage opportunities, as indicated by the publicly available information, then every market participant will try to make profit from riskless covered arbitrage and the opportunities will thus disappear.
Whether or not markets are efficient has significant implications for the operations of international business firms.The international parity conditions that we have come across so far (PPP and CIP)and those we are going to discuss in this section (UIP and RIP)have important implications for the international firm’s investment and financing decisions as well as its exposure to risk.These conditions hold only if the underlying markets are efficient.In this sense market efficiency precludes the possibility of earning profit via arbitrage and speculation based on the violation of these conditions.
There are three levels of efficiency, which are defined with reference to the contents of the underlying information set.These concepts are explained with reference to the foreign exchange market.
Weak efficiency
Weak efficiency means that prices reflect all the information contained in the past behavior of prices (or rather exchange rates).This is obviously a limited set of information as it excludes the effect of other relevant variables that, in the case of the foreign exchange market, affect the exchange rate.If the foreign exchange market is weakly efficient, this means that the future behavior of exchange rates cannot be predicted from their past behavior.This proposition casts doubt on the reliability and usefulness of time series and technical forecasting as well as the mechanical trading rules.
Semi-strong efficiency
Semi-strong efficiency implies that the information set contains not only the past behavior of exchange rates, but also all publicly available information.In the case of the foreign exchange market, public information pertains to the variables that affect exchange rates, economic and otherwise.Economic news as released by the authorities (the Reserve Bank and Treasury)is publicly available, since it is reported by the media as soon as it is released.This information includes statistics and analysis pertaining to inflation, growth, unemployment, the balance of payments, the money supply, public debt and any other economic variables that may cause changes in the supply and demand forces in the foreign exchange market.Relevant information also includes various reports and analyses prepared by the media and financial institutions and made publicly available.Non-economic factors include such things as cabinet reshuffles and changes in government.If the foreign exchange market is efficient in this sense, then even research into the fundamental factors affecting the exchange rate will not help us to predict its future behavior.This level of efficiency casts doubt on not only the reliability of technical and time series forecasting, but also econometric forecasting models, which are built on the basis of some underlying economic theory.
Strong efficiency
Strong efficiency implies that prices reflect all available information, including private information and insider information.It is normally argued that this level of efficiency does not apply to the foreign exchange market because, unlike the stock market, insider information is not important.However, it is not difficult to come up with examples of insider and private information pertaining to the foreign exchange market.Insider information may be obtained by having dinner with an official of the Reserve Bank who (private)transmits knowledge of plans for intervention in the foreign exchange market or plans to change the exchange rate arrangement.Insider information can also be transmitted by Treasury officials who are aware of hitherto unreleased information pertaining to changes in macroeconomic policy that are bound to affect the exchange rate.Private information may arise when, for example, an analyst develops a profitable trading rule that is not revealed as public information.If the foreign exchange market is efficient in this sense, then even insider and private information can not help us to predict the future behavior of exchange rates or to make abnormal profit.