Does the Efficient Market Theory Apply on the Forex Market - Literature review Example

? Does the efficient market theory apply on the forex market Fundamental analysis Vs. Technical analysis Introduction In the international trade, the buyer or seller of the products wants to have payment in his home currency. This needs an exchange of currencies from that of a seller to that of a buyer. Any international trade will involve in any two instantaneous transactions: Exchange of the products in a physical form Sale or purchase of foreign currency In any international trade, the sale or purchase of any product will affect only one the parties in the foreign exchange. Suppose, If a British importer buy ? 100,000 worth of products from an American manufacturer, and the invoice is billed in US$, the burden falls on the British importer to buy ? to complete that business transaction and vice-versa. Thus, the party assumes the risk that the exchange rate on that specific date of conversion is positive to that party. (James, Neelankavil & Rai 2009:246). The Forex market is operating on an international basis where currency of each nation is bought and sold freely. The forex system was introduced in the 1970s at the time of introduction of free exchange rates and the price of one currency, and the price of one currency against another that happens from demand and supply that are only decided by the market participants.(Dicks 2010: 5). Forex market can be termed as a perfect market as it cannot be either monopolised or controlled by any of its participants. Due to ever increasing number of transactions on a daily basis makes it as the biggest liquid financial market and as per an estimate, money transaction involves in the forex market form up to US$ 6 trillion per day. This figure is only a tentative figure as the exact amount cannot be quantified due to the transactions are not centralised on a forex single exchange. With the help of telecommunication, trading is carried over all over the globe and with electronic networks with five days in week and 24 hours a day and there are dealers quoting currencies in each time zone through the main central markets: New York, London, Frankfurt, Hong Kong, Tokyo, New Zealand and Australia. (Dicks 2010: 5). The forex market is being able to maintain its goal and avoid being manipulated or controlled by any few or one of its participants since the volume transacted is so high that if any of them would want to distort by changing price at their volition, they have to operate with hundreds of billions of dollars. That is why forex market cannot be swayed by any single participant and even though, there are scenarios where large transactions can appear to assume control of the forex market for a few minutes, the balance is restored again instantly due to the great liquidity associated. This also permits traders to derive revenues by closing and opening positions within a few seconds. (Dicks 2010: 5). The place or venue for the sale and purchase of foreign currency is called as the foreign exchange market. This research essay will make a complete literature review on an efficient market hypothesis of forex market, including fundamental and technical analysis, also offers a brief history on the forex market and overview of the market in an exhaustive manner. Definition of Foreign Currency A foreign currency rate denotes to the price any person pays in one currency to buy another currency. It is to be observed that a currency is analogous to any other product namely food or gold; its price is decided by the supply or demand for the said product. For instance, if a forex dealer quotes US$ 1.35 per ?, then he is quoting US$1.35 for the sale or purchase of per ?. (James, Neelankavil & Rai 2009:247). Quotes for exchange rates are available either for instant release or for the future delivery. For the immediate delivery, the price of foreign currency is known as spot rate. Due to introduction of advanced IT in the forex transactions, now it is made possible for a spot transaction to be cleared or settled on the same day is possible. The largest consortium of the globe’s largest banks known as CLS Group is now able to settle all spot transactions in forex for more than 50 currencies on the same day. The main aim of the group is to offer same-day clearing and settlement services for all currencies in the world. (James, Neelankavil & Rai 2009:247). The Market Efficiency Theory If exchange rates are immediately and fully mirror all available information in a forex market is said to be efficient. The notion of market efficiency should be clearly differentiated from the concept of market perfection. Though, market perfection is definitely a sufficient condition of market efficiency, but it is not an essential one. As long as transactions take into consideration all available data , even large transaction costs that hinder the flow of transactions do not in themselves indicate that when transactions do take place , exchange rate may not “ fully mirror” all available data. Three grades of market efficiency are traditionally distinguished by Eugene Fama for empirical testing objectives in the background of stock price, and they are: The weak efficient market theory corroborates that chain of historical exchange rate include no data that can be employed to predict future spot exchange rates. The semi-strong type of market efficiency reflects that a competitive and large group of market participants has access to all public available data that can be employed as the basis for the formation of anticipations about future rates; and finally If the set of available data also includes insider or private data, then forex market is said to be strongly efficient. The distinction between strong and semi-strong forms of efficiency may not be as specific to the forex market, where insider trading is not an issue. (Fama 1970:385). Financial ideologues describe three kinds of the market efficiency theories: “Weak type efficiency indicates that all data included in the historical exchange rate flows is wholly mirrored in forex exchange rates, thus creating data about current movements in a currency’s value unproductive estimating.” “Quasi-strong type of efficiency indicates that present exchange rates mirror all openly accessible data, thereby facilitating such data ineffectual for predicting future movements.” “Robust kind of efficiency indicates that present exchange rates mirror all relevant data, whether privately or publicly obtainable, thereby facilitating to prevent insiders also not to receive unusual profits.” “Statistical examination of the competent market theory has not offered much back up, in any case for the robust type.Majoirity of research backs the feeble type, while there are assorted outcomes as regards to the semi-strong form.” (Fama 1970:385). Two major factors are said to be the litmus test of market efficiency: the magnitude of statistical dependence between consecutive movements in exchange rates and the profitability of trading regulations. In essence , what is being examined is whether the past chain of exchange rates includes useful data for the estimation of future spot rates , thus implying that general patterns would occur themselves at regular periods? Research pertaining to the first issue on common statistical mechanisms like runs analysis and serial correlation analysis is to decide on the magnitude of reliance between successive exchange rate changes. (Jacque 1997:110). One hypothesis demonstrates that the past exchange rates include useful data in projecting future exchange rates since the data only spreads slowly among market participants , thus contradicting the market efficiency hypothesis. Poole in his empirical study has established substantial serial dependence in the currency price-rates of change by employing tests of serial correlation, filter rules and variance-time function. Pool attributed his research findings of serial reliance to transaction and inventory-carrying costs. Dooley and Shafer (1976) found a substantial serial correlation in exchange rate series, thus doubting the Market Efficiency theory and a contrario, offering empirical proof for the Price Dynamics theory of exchange rate behaviour. Giddy and Dufey (1975) in their research study of comparative projecting correctness of five models, proved that the behaviour of spot exchange rates is best illustrated as following a random walk, an outcome clearly dependable with the weak form of market efficiency. More particularly, exchange rate behaviour was proved to be best approximated by stochastic processes either submartingale or martinggle type, with the implications that the best estimators of future spot exchange rates are present exchange rates finetuned for interest rate variances. (Jacque 1997:110). Logue and Sweeney (1977) established substantial evidence , employing spectral analysis that price change in the French Franc –U.S dollar spot exchange market over the period of 1970 -1974 was random. Sweeney (1986) and Dooley and Shafer (1983) , employing filter trading regulations found that abnormal profits over the phases 1973 -1981 even after adjusting for income/interest expenses and transactions costs in bid-ask spreads. How the theory of efficient market hypothesis is being opposed by sceptics? “Many economists are of the view that the forward rate is the top existing estimator of future spot rates and that the exchange rate may be estimated by a stochastic walk.” Recent research studies shed disbelief on the efficient market hypothesis and on the above claims. However, some research studies have revealed that certain trading methodologies are able to make optimistic surplus revenues. Fundamental Analysis Fundamentals can impact the demand for a currency. Fundamentals can impact the supply of currency. Fundamentals refer to the movement in the forex market. It is to be noted that all financial and economic happenings around the world right from the performance of New York stock exchange to the number of barrels of oil Saudi Arabia produces and other thousands of such happenings around the world could be considered as the fundamental factor that could have an effect on the Forex market at any given point of time. (Jagerson & Hansen 2006:68). Fundamentals in Forex market differ from an investor to an investor. Certain Forex investors may be spotlighting on the stock market in London, whereas some Forex investors may focus on commodity prices. Thus, what is significant to one investor may not be relevant to another investor in Forex market. Many varied fundamental factors have impacted the Forex market in the past and some of these fundamental factors will be likely to assume a greater role in shaping the future of the Forex market while many other fundamental factors may not. (Jagerson & Hansen 2006:68). Some of the fundamental factors that impact Forex market are listed below; Fundamental Factor Fundamental Tool Inflation Consumer Price Index(CPI) U.S Government Interest rates , Treasury International Capital ( TIC) data China and other emerging markets Balance of trade U.S Dollars vs. Chinese Yuan ( USD /CNY) U.S Stock Market S& P 500 Breaking News News Media Oil Crude oil futures (Jagerson & Hansen 2006:68). Fundamental analysis will include the analysis of the revision of macroeconomic pointers, political decisions and the stock markets as such decisions manipulate the climate of stability of the nation in question and in the government concerned. Along with the rising macroeconomic indicators and with greater confidence on a government, this will have higher level of confidence on a trader in making the required decision. In arriving out the strong fundamental, a trade will look into the rates of growth, types of interest, the GDP, the monetary mass, the existing inflation rate in a country, the productivity and the foreign currency reserves. Sometimes, government may intervene through the central bank and such interventions will have a striking effect, but they are normally of short phase. Following macroeconomic variables published by the relevant governments will help traders to estimate the future behaviour of a currency. The following table lists some of the significant variables. GDP ( Gross Domestic Product) Economic growth can be estimated through the GDP figures published quarterly. This variable is significant as it shows how GDP of a country is growing and in such situations, there will be higher investments, savings and consumption. A higher GDP would push the currency quotation to the higher side and vice-versa. Price developments- The depreciation or appreciation of a currency with another currency is normally nuetralised by the change in differential of the interest rates. Inflation Currencies with higher interest rates will always be regarded to be more attractive due to the probable containment of inflation and an implicit greater profitability. Likewise, a greater CPI will push the exchange rate on higher side and vice-versa. Unemployment This pointer though hard to estimate but its weight is significant as it will have an impact on both consumptions and incomes of families. If the unemployment rate is higher, then currency will move downwards and vice-versa. Trade balance When there is a stable balance of payments, then the equilibrium point of currency will be there. The currency of a nation experiences a reduction when a country faces a trade deficit. Stock Market Day to day currency evolution has a larger correlation with asset market of a country, particularly with stocks. When investors regard a nation as a good destination to invest that market of assets or assets will be incremented by the inflow of other currencies and hence, the value of the nation’s currency will remain robust. (Dicks 2010:125). “Fundamental analysis is a kind of foreign exchange projecting method that employs basic association between exchange rates and fiscal variables.” The economic variables employed under this include changes in money supply, national income growth, inflation rates, and other kinds of macroeconomic variables. Computer based econometric models is being presently used to make the fundamental analysis. Purchasing power parity is the simplest form of fundamental analysis, which is being widely used. “The purchasing power parity theory explains that symmetry transformations in the exchange rate to transformations in the proportion of foreign and domestic prices.” (Dicks 2010:125). Technical Analysis Technical analysis mingles the influence of aggregate of the fundamentals impacting a market into one element, the present price. Traders can analyse price trends with the help of a chart, comprehending that the price combines every feature known to the market at the contemporary phase –at least, in the perception of traders. The data that forex traders actually require for their technical analysis shoots up from the answers to the following questions: Towards which direction the market is forwarding? How robust will the move be? When will the current trend lose its vigour, establishing a bottom or a top? What will be tomorrow’s low or high will be? Many forex traders initiate with fundamental chart analysis like chart patterns and trend analysis. (Mendelsohn 2006:38). Traditionally, technical analysis in the futures markets have focused on the six price fields available during any given phases of the period namely high, open, close, low , open interest and volume. As the forex market does not have any central exchange, it is intricate to calculate the fields like open interest and volume. Technical analysis includes chiefly of a variety of technical studies, each of which can be construed to estimate market direction or to create sell or buy signals. One common important tool is shared by many technical studies that stress chosen characteristics in the price motion of the underlying security. One chief benefit of technical analysis is its “visualness” as a picture is worth than that of a thousand words. As per Taylor and Allen (1992), more than 90% of foreign exchange dealers in London who replied in a survey that they used some guises of technical analysis to make their trading decisions? Murphy (1986) stresses those asset price changes frequently lead celebrated transformations in fundamentals. For success of any technical analysis, predictable trends are indispensable, since they help traders to book profit by selling or buying when price is rising or falling. Practioners can well apply the Newton’s law of motion to illustrate the presence of trends. Unless acted upon by another force, trends in motion tend to remain in motion. The technical analysis also gives significance to technical analysis, which is based on historical data. Forms of Technical Analysis Chart Analysis - To identify price trends, support, ranges and resistance levels, use of visual inspection of price charts. Momentum and trend analysis: As regards to the price movement that looks at the rate of change of prices for indications of market sentiment. Trend pointers attempt to decide the presence of a trend and its strength. Pattern Recognition: It recognises chart patterns or formalities that offer particular predictive indicators like a breakout or a reversal. (Galant et al 2010:179). Bar Charts These charts are very popular since it can be easily to construct and comprehend. As a vertical bar, these charts are drawn by symbolising daily, intraday, monthly or weekly activity. The specialty of the bar chart is that since it can present the data individually, without bonding prices to neighbouring prices and each set of price fields is denoted by a single island. Nowadays, computers are an apparent aid to carryout technical analysis studies, both for testing old ones and finding new methods. A computer can handle complex data sets and ideas, and it can be easily manoeuvred by a computer nowadays. A computer can examine a trading method fastly and over a large set of historical data. (Archer 2010:261) Burton’s system bar graph was developed by Burton Pugh in the 1930s. His replica associated with the connection of the current set of quotes with that of a previous set of quotes, which creates a continuous line representation of price movements. (Archer 2010:118). Charting can be said to be a very subjective structure that needs the market analysts to employ skill and judgment in interpreting and finding the patterns. Mechanical rules, on the other hand, offer discipline and consistency for technicians by demanding them to employ rules footed on mathematical functions of past and present exchange rates. As per Clements (2010), technicians of late, are more commonly employing many newer pointers that also employ mathematical functions to decide whether to sell or buy. Other than mechanical and charting methods, analysts also employ many other varieties of pointers. Such pointers allocate a special task to round off numbers in resistance or support levels. For instance, technicians understand a crossing of an important level, such as dollar/yen rate of 100, as pointing further movement in the similar direction. Osler (2003) is of the opinion that when an exchange nears a round number say 100 yen to the dollar, it is likely to turn around its path. However, when an exchange rate does cross such a stage, it appears to move fast. As per Osler (2005), limit orders to the very high quantum of volatility in exchange rates. Murphy (1986) deliberates about a variety of more mysterious methods like Fibonacci numbers, Elliot wave, and many forms of other technical perceptions. Further, traders occasionally employ technical analysis of one market price historical data to assume positions in another market, a system which is known as Intermarket technical analysis. (Neely and Weller 2011:5). Technical analysis is another kind of currency forecasting procedure that employs past trends or prices. “This kind of analysis spotlights purely on historical volume and price trends not on political and economic components. The strategy is to dispose off or purchase some currencies if their prices diverge from historical models.” “Charting is a variety of scientific studies where predictors employ charts to discover troughs and pinnacles in the price orders and then employ these indicators down and up movements.” “Mechanical regulations are a kind of scientific study where an authority of rules is employed to assist and to formulate this skewed process more conditioned.” Local troughs are named as support levels and local peaks are named as resistance stages. “A filter rule implies that traders purchase a foreign currency when it ascends higher than a specified fraction well higher than it back up stage and then dispose a foreign currency when it declines well below the specified percentage of its resistance stage.” (Archer 2010:261) “A market-oriented prediction employs market signals to predict exchange rates footed on the notion that these markets signals competently integrate anticipated future currency movements.” “Transnational companies (TNCs) often follow movements in the spot rate and then employ these movements to approximate the future spot rate.”TNCs also frequently presume that the present forward rate is a harmony estimation of the spot rate in the long run.” It is to be noted that the estimating of forward rates is restricted to about twelve months.TNCs employ interest rate differential to calculate exchange rates beyond twelve months. (Archer 2010:261) It is to be observed that past empirical studies carried on trend analysis like “Martin (2001), Lee, Gleason and, Mathur (2001), Gencay (1999), Neely, Weller, and Dittmar (1997). Dooley and Shafer (1984), Sweeney (1986), Levich and Thomas (1993), and Poole (1967) have corroborated that technical analysis can create continual profits.” Taylor and Allen (1992) and Allen and Taylor (1990) have conducted a survey on main foreign exchange dealers functioning in London and their study exposed that majority of these London based foreign exchange traders employ technical analysis to some magnitude, and they are likely to mingle it with fundamental analysis. The authors also found that the relative significance embedded with technical analysis is higher at lesser horizons. Taylor and Allen (1992) have found that ninety percent of the interviewees replied that they employ some guises of technical analysis to make their forex trading positions. Further, they also discovered that in the short span of a period say less than a week- technical analysis outweighs the fundamental analysis which employs economic variables like output growth and interest rates to offer guidance to their trading decisions. As per Cheung and Chinn (2001), about thirty percent of U.S based foreign exchange traders could best be distinguished as technical analysts and the technical analysis is increasingly being used in U.S now. Cheung, Chinn and Marsh (2004) have corroborated earlier research findings that forex traders always offer greater significance to non-fundamental factors (technical) at shorter phases. Oberlechner and Osler (2008) employed survey proof from four-hundred North American foreign exchange traders to create that interviewees miscalculated improbability and over-confidence of their capacities. Menkhoff and Schmidt (2005) have explored the employment of buy-and-hold impetus and investor trading strategies and found that momentum traders were the least risk –antipathetic and investing traders have shown indications of impudence. How effectiveness is the past empirical evidences on forecasting. In general, the outcomes of analysation of estimating efficacy are varied. “Meese and Rogoff (1983) assessed the efficacy of two market-oriented estimates (forward rate and spot), three fundamental models and two technical models.” “They founded that footed on RSE that market-oriented predictions are exactly precise than fundamental and technical replicas and that, as the fundamental for estimating, the forward rate is lagged behind the spot rate in performance. “Goodman (1979) assessed six primarily tailored estimating firms as regards to precision in estimating accuracy and trends of their point estimates employing the forward rate as a yardstick. He discovered that no private firm was radically performed better or more accurate than the forward rate.” “Eun and Sabherwal (2002) assessed the forecasting execution of ten key mercantile banks as contrasted to the casual walk model. He found that no bank could strike the market, i.e. no bank could strike the random walk.” Fundamental Analysis vs. Technical Analysis Fundamental analysis concentrates on topics like governmental policy , economic data , global news ,socio-political conditions, inflation ,interest rates ,economic growth , central bank policy , employment , housing , commercial production , industrial production and the business cycle, whereas technical analysis is concerned primarily with interpreting price action. Fundamental analysis can offer a structure for formulating a long-term opinion on the global currency markets where technical analysis excels at offering logical trade entries and exits. An individual foreign exchange dealer could surely try to place trades footed solely on a fundamental comprehending of political and economic factors and the placement of trade exits and entries could be regarded significantly a subjective act without the exact exit /entry methods of technical analysis. The fundamental analysis is a significantly indispensable and vital aspect of successful foreign exchange trading, and the market perceptions or fundamental factors are essentially what make the currency markets move. Technical without the fundamental makes the trade not a full-fledged one as the trader can only deal with fundamentals only. (Chen 2009:105). Conclusion Trading in forex markets is heavily influenced by technical analysis as it is not only widely employed approach but also a popular mechanism among forex traders. Evidence from various surveys indicates that technical analysis overshadows fundamental analysis at short horizons. During the 1970s and 1980s, the technical trading rules were able to offer excess returns as the same had been corroborated by various researchers. It is to be observed that now returns on forex markets is based on more sophisticated or complex rules. At present, employing modern computer programs, data mining can help a forex trader to maximise his profits. Further , various empirical studies have discovered that if central banks have intervened to stalk robust trends in the nation’s exchange rate, then technical trading rules can help a trader to maximise his revenues. Hence, for technical rules, the period of intervention by the central bank has been correlated with phases of high profitability. The existence of abundance of behavioural models can now regenerate the trending pattern of foreign exchange markets and demonstrate that technical trading can be time and again profitable in some scenarios. The changing nature of behavioural models offers a promising structure in which such replicas can be further expanded. Thus , if one uses technical analysis like Stochastic Oscillator when a trader wish to recognise oversold and overbought scenarios ,seeking out sell and buy signals and understanding the bearish and bullish divergence , one can earn real profits in the forex markets with less risk.( Harman 2011). It is to be observed that past empirical studies carried on trend analysis like Martin (2001), Lee, Gleason and, Mathur (2001), Gencay (1999), Neely, Weller, and Dittmar (1997). Levich and Thomas (1993), Sweeney (1986), Dooley and Shafer (1984), and Poole (1967) have corroborated that technical analysis can create continual profits. Taylor and Allen (1992) have found that ninety percent of the interviewees replied that they employ some guises of technical analysis to make their forex trading positions. Cheung, Chinn and Marsh (2004) have corroborated earlier research findings that forex traders always offer greater significance to non-fundamental factors (technical) at shorter phases. Hence, I wish to vote for technical analysis to gain profits in the forex market as corroborated by various abovementioned findings than that of fundamental analysis. List of References Archer, Michael D. (2010). Getting Started in Currency Trading: Winning in Today’s Forex Market. New York: John Wiley and Sons. Chen James. (2009). Essentials of Foreign Exchange Trading .New York: John Wiley and Sons. Dicks, James. (2010). Forex Trading Secrets: Trading Strategies for the Forex Market. New York: McGraw –Hill Professional. Fama, Eugene. (1970). “Efficient Capital Markets: A Review of Theory and Empirical Work.” Journal of Finance, 25 (2), p 383-417. Galant Mark, Dolan Brian & Galant Mark. 2010 Currency Trading for Dummies. New Delhi: Wiley India. Harman, Sylvia. (2011, 16 April). Key Things You Need to Know About Forex Trading Strategy. [online] available from < http://ezinearticles.com/?Key-Things-You-Need-To-Know-About-Forex-Trading-Strategy&id=6184021> [accessed on 20 April 2011] Jacque, Laurent L. (1997). Management and Control of Foreign Exchange Risk. New York: Springer. Jagerson, John & Hansen, S.Wade. (2006). Profiting with Forex: the Most Effective Tools and Techniques for Trading, New York: McGraw Hill-Professional. James P, Neelankavil & Rai Annop. (2009). Basics of International Business. New York: M.E.Sharpe. Levich and Thomas (1977) revealed that simple trading rules constantly paved to abnormal profits. (Jacque 1997:113). Mendelsohn, Louis B. (2006). Forex Trading Using Intermarket Analysis. New York: Market Technologies. Neely J Christopher & Weller, Paul A. (2010 18 December).Technical Analysis in the Foreign Exchange Market. [online] available from< http:// research.stlouiffed.org/wp/2011/2011-001.pdf .[accessed on 20 April 2011] Read More