Working Paper: NBER ID: w14597
Authors: Richard M. Levich; Valerio Poti
Abstract: This paper studies predictability of currency returns over the period 1971-2006. To assess the economic significance of currency predictability, we construct an upper bound on the explanatory power of predictive regressions. The upper bound is motivated by "no good-deal" restrictions that rule out unduly attractive investment opportunities. We find evidence that predictability often exceeds this bound. Excess-predictability is highest in the 1970s and tends to decrease over time, but it is still present in the final part of the sample period. Moreover, periods of high and low predictability tend to alternate. These stylized facts pose a challenge to Fama's (1970) Efficient Market Hypothesis but are consistent with Lo's (2004) Adaptive Market Hypothesis, coupled with slow convergence towards efficient markets. Strategies that attempt to exploit daily excess-predictability are very sensitive to transaction costs but those that exploit monthly predictability remain attractive even after realistic levels of transaction costs are taken into account and are not spanned by either the Fama and French (1993) equity-based factors or the AFX Currency Management Index.
Keywords: currency markets; predictability; efficient market hypothesis; transaction costs
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| volatility of the pricing kernel (G19) | predictability of currency returns (F31) |
| high predictability (D80) | existence of exploitable trading strategies (D84) |
| frequency of trading (G14) | ability to exploit predictability (D84) |
| transaction costs (D23) | exploitability of predictability (D84) |
| periods of high predictability (E32) | periods of low predictability (E32) |