Efficiency of the Exchange Market

The latest global financial crisis has proved that the financial markets are not very efficient and their deregulation has caused serious risk and wealth redistribution problems. The international monetary system had to accommodate extraordinarily large oil-related shocks, monetary shocks, trade deficits, privatizations (sell-offs of State Own Enterprises), Foreign Direct Investments, outsourcings, globalization, and public and private debts that affect capital flows among nations, and risk. Surpluses had to be recycled (invested) by buying financial assets from the deficit countries, which are at a low market price (undervalued) and the benefits to the sellers are insignificant. The continuous financial and debt crises have increased uncertainty and the deregulation of our financial institutions has increased the gap (“brain spread”) between the market and liberal politicians and deteriorated the agency problem between people (the principals) and government-market (the agents). Labor has lost some its rights and it is exploited in many countries, as Chomsky (2014) says. The increased interdependence among nations, due to globalization, and the realization that economic policies by strong nations exert pressure on other weaker economies, has to induce legal responses and cooperation among all nations.

An understanding of efficiency, expectations, risk, and risk premium in the foreign exchange market is important to government and central bank policymakers, international financial managers, and of course, to investors and to everyone interested in international finance. The government policymakers need to design macro-policies for achieving the goal of maximization of their social welfare through efficient resource allocation. Central banks have to be public and responsible for the wellbeing of the citizens of their own country.

International investors and financial managers need to assess foreign asset returns, risks, and their correlations in order to make optimal portfolio decisions. The foreign exchange market efficiency hypothesis is the proposition that prices (exchange rate movements) fully reflect information available to market participants. There are no opportunities for hedgers or speculators to make super-normal profits; thus, both speculative efficiency and arbitraging efficiency exist. Numerous studies have been tested for speculative efficiency and arbitraging efficiency by testing the following three hypotheses respectively:

(1) The forward discount or premium is a good predictor of the change in the future spot rate, implying covered interest parity (CIP), uncovered interest parity (UIP), and rational expectations to hold.

(2) The forward discount tends to be equal to the interest differential, implying that CIP holds.

(3) The expected risk premium is zero