Speculator Activity and Cross-Asset Predictability of FX Returns

Abstract

The gradual information diffusion hypothesis (GIDH) suggests that information flows slowly across investors and asset markets and thus generates return predictability. We examine cross-asset return predictability of FX market strategies. Apply the GIDH to empirically investigate the role of speculator activity in cross-asset return predictability of FX market strategies. We hypothesize that when speculators in the FX market are active, the speed of information diffusion into the market increases which, invariably, weaken predictability between the equity and commodity market and FX strategies. Our reported results, which provide strong support for this view, show that when speculators are active in the FX market, predictability from the equity market dissipates and predictability from the commodity market diminishes. Our findings suggest that speculators play a vital role in enhancing informational efficiency in the FX market.