Ebook Market Efficiency, Cointegration and Causality
An efficient market is where the prices always fully reflect all available information. The efficient market hypothesis (EMH) implies that the expected profit or loss from speculative behaviour must be zero. Adding the assumption that the individuals are risk neutral implies that the current forward rate is an unbiased predictor of the future spot rate. An approach to conclude whether the market is efficient is thru statistical methods for stationarity and cointegration tests, such as Hakkio and Rush (1989), who employ cointegration tests for market efficiency between forward and spot rates, i.e. testing if the forward and future spot share the same stochastic trend. Their results from the cointegration tests are consistent with market efficiency, but when using error correction equations they reject the joint hypothesis of no risk premium with efficient use of information.
The purpose of this paper is to investigate whether the spot rate on Swedish kronor per US dollar is cointegrated with the forward rate with different contract maturities. Economic theory implies that if the market is efficient, then this should be the case. Hakkio & Rush (1989) explain that if two variables are not cointegrated, so that their difference is non-stationary, then with probability one, they will drift infinitely far apart. Thus, if we can’t conclude that the spot and forward rates are cointegrated, then we can’t conclude that the foreign exchange market is efficient.
The remainder of the paper is organized as follows: In the next section we discuss the implications of foreign exchange market efficiency. Furthermore, we also present the theoretical framework of cointegration, causality, vector autoregressive models and vector error correction models. In section three we present the data and the methodology. Section four presents our empirical results. A short summary and the concluding remarks are presented in section five.
contents
1 INTRODUCTION
2 THEORETICAL FRAMEWORK
- 2.1 Efficient Markets
2.2 Tests for unit roots and the Engle-Granger method for cointegration
2.3 VAR, VECM and Granger causality
2.4 Johansen cointegration test
3 DATA AND METHODOLOGY
4 EMPIRICAL RESULTS
5 SUMMARY AND CONCLUDING REMARKS
References
Appendix A – Results from ADF, PP and E-G methodology
Appendix B – Lag order selection criteria
Appendix C – JLR test results
Appendix D – VECM, ECM and Granger causality
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