Studies on Forecasting Foreign Exchange

Essay by neetusethiUniversity, Bachelor'sA, April 2009

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The subject of forecasting the exchange rate has attracted scrutiny and an overwhelming body of work has been done in the past. A large body of work has sought to accurately forecast the exchange rates. A study of the work done shows that there is a debate regarding whether the exchange rates follow a random walk or can be modelled. A debate also persists whether the structural models, linear, non-linear time series models best forecast the exchange rate.

2.1 EMH and the Random Walk TheoryThe concept of efficient market was introduced first by Fama et al.,(1969) who defines an efficient market as a market which "rapidly adjusts to any new information". Though the rapid adjustment to new information is an important element of an efficient market; it is not the only one. A new definition was put forward by Fama (1991) that states that the asset prices fully reflect all available information.

This is a stronger definition of the EMH. This means that it is impossible to outperform the market consistently because currency prices already incorporate and reflect all relevant information. Grossman & Stiglitz (1980) concludes that if the information was "fully reflected" in the asset prices, there will be no financial incentive to obtain that information. Since, the information is costly; there must be a financial incentive to obtain the information. A more realistic definition is put forward by Jensen (1978) who defines market efficiency as "A market is efficient with respect to information set θt (represents the information available at time t) if it is impossible to make economic profits by trading on the basis of information set θt". The competition to take advantage of any mismatched exchange rate is intense. So when new information about mismatched rates comes out, investors rush to take advantage of it and...