Does the efficient market theory apply on the FOREX market - Essay Example

?Does the efficient market theory apply on the FOREX market Fundamental analysis Vs. Technical analysis Background It was suggested by Obstfeldand Rogoff (2000) that the exchange rate is the single crucial relative price in the economy because it spreads into a vast range of other transactions. But since the inception of the floating rate in the 1970s and 80s the exchange rate has become too volatile in the short term range to be fully explained by the fundamental based exchange rate theory. That’s the reason for triggering the debate between the fundamental and technical analysis. This is an ongoing debate between the fundamental and technical analysis. The question is, which one is better in terms of profitability? Just to give you in insight to the battle between the fundamental and technical analysis; the technical analysis is based on the price movement of the stock whereas the fundamental analysis is done based on the study of financial statements and statement of cash flows and various other fundamental economic indicators. 2. Statement of the problem Realistically speaking, the efficient market hypothesis is applicable to the foreign exchange market. The technical analysis is based on the price movement of the stock. Any company with a transparent history of the stock trade is potential candidate for technical analysis. Consider two people who are studying a company. Both of them are looking to invest in the company (to buy its stocks). The person “A” who is a fundamental analyst will be looking at the product of the company, its finances and management to evaluate its value. Based on these tools, he will see if the value of the current price of the stock is less than its intrinsic value. In that case, he will buy the stocks. On the other hand, you have the person “B”, who is also studying the same company to invest in. This person is a technical analyst, he will not study the fundamentals of the company, i-e the financial statements, the statement of cash flows and the income statement. He will simply look at the stock’s performance in the history. He will try to squeeze out some pattern from the past performance of the stock. This study is usually done through reading the past charts of the stock’s performance, highlighting the ups and downs. If the trend is looking upwards, the person “B” will buy the stock. In both cases, both persons got to the same conclusion of buying the stock of the same company, but their methods were entirely different. The person “B” does not even have to visit the company to do the technical analysis. Now implying the same method on the foreign exchange market, we can deduct whether the efficient market hypothesis is workable in the FOREX market or he not. For that we need to know the basics of the efficient market hypothesis. The efficient market hypothesis can be viewed as having three levels or stages; the weak form, the semi strong and the strong form. The weak form or the weak stage states that the price of the security or stock at any point in time reflects the true value of the stock, meaning that we cannot predict the stock’s movement from the price of the stock. All the values or the fundamentals of the company (all the negative and positive aspects) are already reflected in the stock price; therefore it is useless to do the fundamental analysis. All the publicly available information has been incorporated in the stock price. The semi-strong form or stage of the hypothesis states that the current stock price reflects all the available public information and the prices instantly change to reflect the new public information. The third stage of string form efficient states that even the insider information cannot affect the stock price. 3. Rationale for the chosen topic My reason for choosing this topic is the huge appeal in the foreign exchange market. The greatest portion of finance is in the foreign exchange by volume. The reason for this trade’s usefulness is that every trade of goods, stocks, bonds, gold silver and the like is done through currency and there comes the conversion process. That is why it is so prevalent that to escape the ups and downs of the foreign exchange becomes impossible. The other rationale is that I’m interested in both the fundamental and technical analysis. I believe in the perfect fusion of the both. One important thing for the efficient market hypothesis to be effective is the assumptions, which serve as the rationale for it. One of the assumptions is that a large number of market participants are constantly analyzing the stocks and bonds. They do it on their own, independent of each other. This gives a more subtle and objective evaluation of the security. The other assumption that makes the hypothesis reliable is that the news (all news) enters market in a random fashion. All the new information that reaches the market is independent of each other. And the consequence is that the investors adjust the values of their securities quite rapidly. The key to the ups and downs of the market is that the investors do adjust to new information rapidly but that does not mean it is correct. The point is that the adjustment is unbiased but that’s it. Some adjustments are under while others are over adjusted; therefore the more careful person figures out the true value of a security and acts accordingly. 4. Aims and objectives The aim of this discussion is to decide whether the efficient market hypothesis is applicable to the foreign exchange market or not. We will try to analyze a small portion from the history of the price fluctuations of the US Dollar Vs the Euro. We will see how the figures react against the technical analysis. We will test their validity and present our conclusion. 5. Research Methodology Efficient Market Hypothesis The efficient market hypothesis is something that explains the exchange rate deviations in the long run from the information and the transaction cost. If there is an absence of information (new info that could influence the security’s price) it would be impossible to determine the future price movement of the security via fundamental analysis and there will no chance for the profitable trading. The excess returns for the security can be described in the following equation. Z (j, t+1) = r (j, t+1) -- E(r (j, t+1) | It) --------------------------------------- (1) Where r (j, t+1) is the actual one period rate of return for holding the currency ‘j’ for the time period which ends at time, ‘t+1’ and ‘E(r (j, t+1) | It)’ is the expected return which can be earned by using that information available at that time ‘t’. According to the equation just described, the exchange market is efficient if the error or the standard deviation on the expected return is zero. And the errors must not follow any pattern, so that no one could predict the future change and extract profit out of it or in other words, the value Z (j, t) has zero correlation with the value Z (j, t + k). The biggest problem that we face with the empirical research on the exchange rate is of the existence of the risk premium. If there is a risk premium involved, then it gets more complicated as how to measure it. Once the interest differential offsets the exchange rate, the domestic and the foreign bonds become perfect substitutes of each other. This strategy eliminates the risk premium factor and any sustained speculative trading profits would be held up as a market efficiency violation. But one thing is worth mentioning here that the portfolio balance model of the exchange rates for the domestic and the foreign bonds are considered to be imperfect substitutes. Hence in equilibrium, the investors do demand a risk premium. It is because of the interest rate differentials to even them off for the incertitude of the exchange rate. Therefore the excess returns must preferably be defined through the following equation Z (j, t+1) = P (j, t+1) – R Pt Where P (j, t+1) is the profit for holding currency j for time t+1 while R Pt is the risk premium which is required at time t. Practically speaking, not many studies have incorporated the risk premium. The reason behind it is the difficulty in distinguishing returns as a result of the market inefficiency. Past Empirical Evidence The oldest and the most used technique for testing the efficiency of the market is to compute the profitability of various mechanical techniques. The most commonly used techniques that are used for this purpose are the filter rule [Dooley and Shafer (1976, 1983), Sweeney (1986), Levich and Thomas (1991), and Neely et al. (1997)] and the moving average rule [Schulmeister (1988), Levich and Thomas (1991), and Neely et al. (1997)]. The filter rule works like this; Buy the security if the value increases from its most recent peak position by some fixed ‘X’ percentage and conversely sell the security if its value drops from its most recent peak position by the same fixed ‘X’ percent. The moving average rule indicates buy and sell notions by the crossover of long and short term moving averages of the past exchange rates. The strategy is quite interesting and simple. If the short term moving average penetrates (cuts) the long term moving average from below, then the indication is of the buy and if the short term moving average penetrates (cuts) from above the long term moving average then the indication is of the sell. Dooley and Shafer (1983) reported the profits of the filter rule trading for a total of nine currencies on the spot rates market over the period of 1973 to 1981. Dooley and Shafer established that the filter rule with a ‘X’ percentage of under the value of five was quite profitable. And this result held true for all the nine currencies over that span of time. Despite the success of the filter rule it was observed that their some risks and losses as during that whole observation at least one currency in at least one sub period bore loss. Thus it was established that the filter rule was not fool proof. There were cracks in its structure. Moreover the rule itself was not based on the sound grounds of stats or Economics. Schulmeister (1988) tested the moving average rule. He tested its profitability for the currency pair of US dollar-Deutschmark. It was conducted between the periods of April 1973 and September 1986. The experiment proved that the moving average rule did generate profit but it was after the adjustments for the interest expenses and transaction costs. It was concluded by Schulmeister that once a currency moved, it more likely to carry on the motion. More like an inertia which propels it. And due to this effect the technical analysts could generate healthy profits out of it. Research strategy (qualitative and quantitative) We have selected the FOREX data from the Jan 1st 2006 to Dec 31st 2010 for USD and EUR on monthly basis. We chose the currencies Euro and Dollar as they are the most heavily traded currencies of the world. Our choice of the currencies eradicates the liquidity issue for the assets under consideration. It is believed that due to the lack of liquidity, an asset does not reflect its true fundamental value. Results EUR/USD Close Percentage Change Moving Average Relative Strength CD Interest Rate 01-2006 1.2146 xxx 1.2449 51.01 4.69 06-2006 1.2790 5.302157 1.2209 59.80 5.46 12-2006 1.3196 3.174355 1.2536 64.25 5.31 01-2007 1.3021 -1.32616 1.2624 60.12 5.34 06-2007 1.3540 3.985869 1.3091 65.01 5.36 12-2007 1.4578 7.666174 1.3708 74.71 4.85 01-2008 1.4848 1.852106 1.3823 77.14 3.71 06-2008 1.5754 6.101832 1.4640 79.37 3.09 12-2008 1.3947 -11.4701 1.4690 49.35 2.18 01-2009 1.2812 -8.13795 1.4560 40.60 1.53 06-2009 1.4035 9.545738 1.3941 52.09 0.67 12-2009 1.4332 2.116138 1.3861 52.61 0.3 01-2010 1.3861 -3.28635 1.3944 48.02 0.29 06-2010 1.2232 -11.7524 1.3878 34.60 0.75 12-2010 1.3417 9.6877 1.3417 48.50 0.41 Data collection methods This data has been captured from the graph of Meta Trader. We have taken three values from each year from year 2006-2010. The closing values of Euro Vs Dollars have been included and the relative strength and the moving average in the same row. Research design In order to test the profitability of the technical analysis we will try to establish the profitability of the filter rule. Analyzing the data one year at a time from 2006 to 2010 we can see that the percentage change trend against the filter rule completely fails. Just by setting our filter to be 2%, all the values absolutely behave against the filter rule indicating the efficiency of market. For example, take the value of the first percentage change which is 5.3%. Now according to our filter rule it is above the value of 2%. Which should predict the exchange movement prediction should be an increase in the value but the next immediate value is almost 3% which contradicts our supposition that the markets are inefficient and they do not follow the efficient market hypothesis. Moving on to the next value indicates a percentage change (drop) of almost 4%. Again it exceeds our filter rule of 2% and the prediction should be that the value of the currency euro against the dollar will decrease but the next value suggests an opposite statement. There is a sudden increase of over 4.5% in the value. Moreover these values are taken over a range of 5 years and they are monthly values, hence they definitely qualify as being the random values to test our theory of market efficiency. This is important because the daily ticks of the market do sometimes predict the movement of the security indicating the market inefficiency but in the table above, it is vividly shown how the markets are behaving in an efficient manner. If our technical indicator of the filter rule is unable to squeeze out profit or unable to predict the exchange value movement proves that the markets are not inefficient. This means that the efficient market hypothesis is valid in the foreign exchange market. Conclusion The study basically discusses two aspects. One is a question whether the efficient market hypothesis is valid or applicable in the foreign exchange market or not. And the second part is discussion, which is about the fundamental analysis versus the technical analysis. The question has been answered that the efficient market hypothesis is applicable in the FOREX market. The discussion portion is still inconclusive as the experts are still debating about the strength and the weaknesses of the two. One thing to understand in the debate, which is often over looked is that there are other methods of predicting the stocks or the securities movements too. Both of the above mentioned analyses do not cover this aspect. The investor sentiment does not fall into any of these criteria. If the data is derived from the options then it would fit in the criteria of technical analysis. On the other hand if the data is squeezed out of opinion polls then it would not be called Technical data analysis. It would neither fit into fundamental part. It will simply called “sentiment analysis”. Works Cited ForeCastChart.com. (2009). CD Interest Rate Charge. Retrieved January 24, 2011, from www.forecast-chart.com: http://www.forecast-chart.com/rate-cd-interest.html Nguyen, J. (2004). The Efficient Market Hypothesis: Is It Applicable to the Foreign Exchange Market? Faculty of Commerce - Economics Working Papers , 21. wikipedia. (2011, January). Answers.com. Retrieved January 24, 2011, from www.wiki.answers.com: http://wiki.answers.com/Q/How_does_technical_analysis_differ_from_the_fundamental_analysis Read More