Predictability and 'Good Deals' in Currency Markets
Richard M. Levich
New York University - Stern School of Business; National Bureau of Economic Research (NBER)
Dublin City University Business School; University College Dublin (UCD) - School of Business; Catholic University S.C. Piacenza
NYU Working Paper No. FIN-08-007
This paper studies predictability of currency returns over the period 1971-2006. To assess the economic significance of predictability, we construct an upper bound on the explanatory power of predictive regressions. The upper bound is motivated by "no good-deal" restrictions that rule out unduly attractive investment opportunities. We find evidence that predictability often exceeds this bound. Excess-predictability is highest in the 1970s and tends to decrease over time, but it is still present in thefinal part of the sample period. Moreover, periods of high and low predictability tend to alternate. These stylized facts pose a serious challenge to Fama's (1970) Efficient Market Hypothesis but are consistent with Lo's (2004) Adaptive Market Hypothesis, coupled with slow convergence towards efficient markets. Strategies that attempt to exploit excess-predictability are very sensitive to transaction costs but those that exploit monthly predictability remain attractive even after realistic levels oftransaction costs are taken into account and are not spanned either by the Fama and French (1993) equity-based factors or by the AFX Currency Management Index.
Number of Pages in PDF File: 51working papers series
Date posted: March 9, 2009
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