Running head: EFFICIENCY IN FOREIGN EXCHANGE MARKETS

Literature Review on the Efficiency of Foreign Exchange Market

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Literature Review on the Efficiency of Foreign Exchange Market

Introduction

Efficiency describes how players in the market can ensure fairness in their transactions

and the sharing of resources. In economics, the concept refers to Pareto efficiency, where society

attempts to improve the well-being of at least one party without worsening the position of the

other party. The idea is to balance the allocation of resources equitably to balance the needs of

everybody in the society. In practice, Pareto optimality is challenging to achieve. In finance,

efficiency refers to the market conditions where the prevailing prices of goods and services

portray the amount of available information. Efficient foreign market exchange efficiency aims

to balance between speculative and arbitrating efficiency in the exchange markets to avoid

supernormal profits for a few players.

Efficient Market Hypothesis

EMH and finance behavior theories have been influential in the analysis of modern asset

pricing. A study by (Fakhry, 2016) notes that the two approaches have opposing views when

explaining the concept of current asset pricing. The financial plan establishes that the price

reaction of the participants on the amount of information available. Conversely, EMH notes that

the price of products and services always depends on open market information. The study

follows previous studies by Daniel & Thomas (2010); de Scitovszky (1943); and Fakhry &

Christian (2015). The issue of information asymmetry is also prevalent in the study, and the

author evaluates how access to information impacts the pricing strategies.

A similar study by ( ğiĠan, 2015) explores the literature surrounding the topic of EMH as

an essential analytical tool used in capital markets. The author notes the varying views on EMH

and its applicability despite being an influential tool in the market analysis process. The study
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focuses on the developing markets and how market changes affect the efficiency in foreign

exchange markets. The study proposes the development of new analytical methods to establish

the effectiveness of capital markets due to constant economic and market changes. The study

follows the previous literature by Birau (2013); Dima & Muregea (2006); Konak & Seker

(2014), whose contribution to the topic influenced the methodological approach adopted by this

study. The study, however, differed with the conclusion of the previous literature by proposing a

modern approach other than EMH to analyze the efficiency in capital markets.

Speculative Efficiency Hypothesis

The speculative market efficiency hypothesis dictates that the forward prices are

preferable in making unbiased future predictions. A study by (Bekiros, 2010) evaluates the

process of making rational decisions in a financial market based on speculative stock conditions.

The research notes that the evolution of modern predictability models will be challenging to the

speculators in the financial markets. The new models are more predictable with enhanced

dynamic time series analysis, and boasting no-linear features that differentiate the model from

the previous models. The study analyzes ten prominent markets in the US, Europe, and Southern

Asia to measure the applicability of the new technical speculative strategy for making trading

decisions. The "chartists" whose rational-based decisions can earn them higher returns if they use

the technical analysis systems that provide predictable turning points to make profits( Hs &Kuan,

2005; Fernandez et al. 2000; Cheng et al. 2007; Hommes, 2005). The new neorofruszzy model

has a higher profitability index than other neural models and the Buy& Hold strategies used in

various countries in Southern Asia.

Besides, a recent study by (Brown & Yang, 2016) on speculative efficiency hypothesis in

betting trade borrows on the conceptual framework used by Bekiros to explain how the concept
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of market efficiency. The study evaluates the impact of speculation in exchange markets to

enhance market efficiency. The of the betting industry is a critical decision because of the

uncertainty involved in this market. The author examines whether speculative trade limits the

possibility of mispricing to establish efficient markets, or it contributes to a further price shift

from the market fundamentals. The study uses a technical analysis model to determine the prices

for betting as the progress of the race and finds an ambiguous trend in the fundamental pricing of

bets. The revelation shows that the speculative approach is not influential in creating a conducive

market efficiency hence the need for a different approach.

Arbitraging Efficiency

The concept refers to the trade that happens in the market by exploiting the existing

differences of identical financial instruments in a capital market environment using different

prices. Arbitrage is a consequence of market inefficiencies that exist due to dysfunctional market

information that leads to imperfect market situations. A study by (Ito & Reguant, 2016) analyzes

the concepts of sequential markets, market power, and the existence of arbitrage in the financial

markets. The author develops an analytical framework to evaluate the strategic characteristics of

a subsequent market occasioned by market limitations of imperfect competitions and entry

restrictions. The study used the data from the Iberian electric market to test this model about the

foreign exchange markets and how they function. The results show that firm characteristics and

price differences show a positive correlation throughout the model. Besides, the study uses a

structural model to show that full arbitrage does not enhance the welfare of the participants due

to power inequalities.

The study relates to another research by (Lewellen 2011) that evaluates the concepts of

institutional investments and the downturns of arbitrage in ensuring market efficiency. The
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author establishes that the stock returns over the past 30 years do not provide adequate evidence

of excellent stock-picking skills. The study also emphasizes that investors are unwilling to bet on

the existing models that predict stock returns, such as momentum, or return-to-book models.

Institutions mimic the market pricing characteristics with a positive correlation between the pre-

cost returns with the Weighted Value Index (WVI) and an insignificant value of CAPM of nearly

0.08%. Most institutions hold a portfolio that is consistent with the market portfolios and show

modest stock-picking skills.

Foreign Exchange Market Efficiency in Developing Countries

Each country chooses between the fixed and floating regimes for exchange rates. Many

developing countries lack established financial systems that lead to exploitation from the

developed nations leading to market inefficiencies. A study by (Firoj & Khanom, 2018)

evaluated the foreign exchange efficiency in Bangladesh by relating to other studies done on

various developing countries. The review uses data from the Bangladesh Central bank using

different exchange regimes used in the country over the past years. The authors establish the

existence of both weak and semi-weak foreign exchange forms of efficiency that impact the

country's economic progress. The common trends show teat Bangladesh loses out in its imports

because of the weak currency and exchange regime that favors other stable currencies such as the

US$ and the Eur €. The study relates to the Bangladesh situation with other developing countries

to evaluate the actual situation in the country's foreign exchange market.

A study by Ibrahim et.all (2011) examined the foreign exchange efficiency among the

OECD member countries. The authors used a weekly foreign exchange data collected over
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7years and tested the data using the PP and ADF to determine the reliability. The study

concludes that most members of the OECD have Weak forms of the FEM.

Chaudhrey & Javid (2012) conducted a study to examine the forms of FEM available in

the South Asian countries of Bangladesh, India, and Sri Lanka and Pakistan. The research

focuses on the exchange rates of some strong economies in the world like the UK Pound, US

Dollar, and the Japanese Yen over more than 20 years. Similarly, the study used the ADF nad PP

data tests to determine the form of efficiency applicable in these countries and the underlying

causes. The study also applied the Granger causality tests to establish the findings and making

conclusions. The authors confirm that the markets in these countries were reliable with the W-

form of the FEM but inconsistent with the strong form of market efficiency.

A study by Mabakeng &Johannes (2014) attempts to analyze the W-form applicability in

Namibia using the traditional form of analysis using unit-roots. The review was among the

pioneer insights into the efficiency of FEM in Namibia, and its findings opened room for further

studies. The authors used the weekly data from the financial exchange of the UK pound, US

dollar, and the Euro for the period between 1993 and 2011. The determination was that the W-

form of the FEM exists in Namibia, pointing towards an inefficient foreign exchange regime in

the country.

Conclusion

The efficient market hypothesis examines the balance between speculative and

arbitraging efficiency in the capital markets. The two concepts help to inform the participants of

the best stock-picking strategy to use in picking stocks. Previous studies on the topics indicate

that there are significant concerns on the analytical tools used in the analysis of financial markets

to determine efficiency. Information asymmetry is a powerful tool used to ensure equality in

accessing resources by all market participants. Developing countries require a new foreign

exchange market to balance trade and ensure FEM for the benefits of all trading partners.

Total Word Count:1521

References

Bekiros, S. D. (2010). "Heterogeneous trading strategies with adaptive fuzzy Actor-Critic

reinforcement learning: A behavioral approach. Journal of Economic Dynamics and

Control, 1153-1170.

Brown, A., & Yang, F. (2016). The Role of Speculative Trade-in Market Efficiency: Evidence

from a Betting Exchange. Review of Finance, 82-107.

FAKHRY, B. (2016). A Literature Review of the Efficient Market Hypothesis. Turkish

Economic Review, 431-442.

Firoj, M., & Khanom, S. (2018). International Journal of Economics and Financial Issues

Efficient Market Hypothesis: Foreign Exchange Market of Bangladesh. International

Journal of Economics and Financial Issues, 99-103.

ğiĠan, A. G. (2015 ). The Efficient Market Hypothesis: a review of specialized literature and

empirical research. Emerging Markets Queries in Finance and Business, 442 – 449.

Ito, K., & Reguant, M. (2016). Sequential Markets, Market Power, and Arbitrage. American

Economic Review, 1921–1957

Lewellen, J. (2011). Institutional investors and the limits of arbitrage. Journal of Financial

Economics, 62-80.
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