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Efficiency of Foreign Exchange Market
Finance & Accounting
Pages 10 (2510 words)
Efficiency of Foreign Exchange Market And Relation between Forward rate and Future spot rate Financial markets have been a mystical area for the researchers. The area is mystical, because over the years it has validated and invalidated numerous theories. One theory that has been validated by a group of researchers in some time frame has been proved invalid by the other researchers on a different time frame.
In efficient markets, there are opportunities neither for the hedgers nor for the speculators to make super-normal profits (Fama, 1970). In such a situation, speculative efficiency and arbitraging efficiency exist. The speculative efficiency hypothesis is the proposition that says if there is speculative efficiency in the market, the expected rate of return to due speculation in the forward foreign exchange market is zero (Hansen and Hodrick, 1980). The arbitraging efficiency hypothesis is the proposition that the expected rate of return to covered or uncovered interest arbitrage in the international capital market is zero. Interest arbitrage is a form of arbitrage where funds are taken out of home country to invest in a foreign country’s interest bearing securities. This strategy tries to make profit from the difference in interest rate of the two countries. Interest arbitrage is a central concept to understand the foreign exchange movements. Literature Review For testing the speculative efficiency of any foreign exchange market, many academicians consider the hypothesis that the forward price is the best forecast available of future spot price. For the test of arbitraging efficiency, several authors test covered interest parity (CIP), i.e. ...
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