PDF Ebook Risk-Premia, Carry-Trade Dynamics, and Speculative Efficiency of Currency Markets
Foreign exchange market efficiency is commonly investigated by Fama-regression tests of uncovered interest parity (UIP). In this paper, we conjecture a speculative UIP relationship which implies that exchange rate changes comprise a time-varying risk component in addition to the forward premium. This suggests that the forward premium anomaly reported in previous research potentially stems from omitting this component in UIP tests and that the popular carry-trade strategy can be rationalized to some extent. Moreover, while related work focuses on the Fama-regression slope coefficient, we show that also the intercept is important for judging the economic significance of currency speculation. Empirically, we find support for speculative UIP and the existence of a risk-premium. Furthermore, although carry-traders are able to collect some risk-premia, currency speculation does not yield economically significant excess returns, which suggests that foreign exchange markets are speculatively efficient. Disregarding the Fama-regression constant, however, leads to distortions in the assessment of economic significance and induces spurious rejection of speculative efficiency.
Tests of foreign exchange market efficiency are typically based on an assessment of uncovered interest rate parity (UIP). UIP postulates that the expected change in a bilateral exchange rate is equal to the forward premium, i.e., given that covered interest rate parity holds, it compensates for the interest rate differential. However, empirical research provides evidence that the forward rate is a biased estimate of the future spot rate, finding that the higher interest rate currency tends to not depreciate as much as predicted by UIP or even appreciates. Attempts to explain the forward bias using, among others, risk premia, consumption-based asset pricing theories, and term-structure models have not been able to convincingly solve the puzzle yet. In a recent micro structural approach, Lyons (2001) argues that while the forward bias might be statistically significant, the failure of UIP might not be substantial in economic terms due to limits to speculation. Compared to other investment opportunities, the Sharpe ratios realizable from currency speculation are too small to attract traders’ capital, who consequently leave the bias unexploited and persistent. The presumption that traders allocate capital only if Sharpe ratios exceed a certain threshold implies a range of trader inaction for smaller UIP deviations.
In this paper, we aim at testing the speculative efficiency of currency markets by assessing the economic significance of currency speculation profits. For this purpose, we take a two-step approach. First, we formulate speculative pendants to the standard UIP test to examine whether currency speculation yields non-zero profits. Second, we judge the economic significance of resulting Sharpe ratios via trader inaction ranges implied by limits to speculation. The trading strategies considered are a static trading approach, i.e. a permanent position in the foreign currency, and the carry-trade. The exchange rate dynamics implied by speculative UIP suggest that exchange rate changes comprise the forward premium and a time-varying risk component which depends on the deviation of the current forward premium from its long-run mean. The forward premium anomaly reported in previous research potentially stems from omitting this risk-premium in standard UIP tests. Furthermore, the carry-trade strategy can be rationalized to some extent in the presence of such a risk-premium. Throughout our analysis, we show that, although related research focuses on the Fama-regression slope coefficient, the intercept is important for judging the economic significance of currency speculation and consequently the assessment of speculative efficiency.
Empirically, we find support for speculative UIP and the existence of a risk-premium, the omission of which results in the forward premium anomaly. Furthermore, although carry-traders are able to collect risk-premia to some extent, currency speculation does not yield economically significant excess returns as judged by trader inaction ranges. Thus, we conclude that foreign exchange markets are characterized by the preponderance of speculative efficiency. Disregarding the Fama-regression constant, however, leads to distortions in the assessment of economic significance and induces spurious rejection of speculative efficiency.
The remainder of this paper is organized as follows. We briefly review the related literature in section 2 and define our notion of speculative efficiency in section 3. In section 4 we derive the speculative pendants to the standard UIP test and describe the exchange rate dynamics implied by speculative UIP. We derive trader inaction ranges to judge economic significance in section 5. Empirical results are presented in section 6, section 7 offers a conclusion. Appendix A provides technical details with respect to the derivation of trader inaction ranges, appendix B describes the procedure for testing whether inaction range bounds are over or undershot.
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PDF Ebook Risk-Premia, Carry-Trade Dynamics, and Speculative Efficiency of Currency Markets
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