Foreign exchange market efficiency and cointegration
Authors: Ferré M.; Hall S. G.
Source: Applied Financial Economics, Volume 12, Number 2, 1 February 2002 , pp. 131-139(9)
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Abstract:
The analysis of market efficiency in the foreign exchange market adopted a new approach after Granger (Oxford Bulletin of Economics and Statistics, 48(3), 1986) stated that assets in an efficient market could not be cointegrated. If they were, there would be a market inefficiency since there would be Granger causality running at least in one direction and thus one price could be used to forecast the other. The interpretation that the literature has given to the relationship between cointegration and market efficiency has been that noncointegration is a necessary and sufficient condition for market efficiency. In the authors' opinion, the fact that two spot exchange rates are cointegrated does not necessarily imply that inefficiency exists. In this article, it is argued that when the economy is composed of N exchange rates and the closed system is analysed without dynamics, as it is the case when considering the no-arbitrage condition, the Granger Representation Theorem (GRT) does not tell one anything about efficiency. Further, when a subset J of the N exchange rates is considered, then the GRT becomes irrelevant for efficiency. To illustrate these hypotheses will be the objective of this article along with that of developing a framework to test for efficiency when cointegration is present.Language: English
Document Type: Research article
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