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Evaluating currency market efficiency: are cointegration tests appropriate?

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  • Neil Kellard
  • Paul Newbold
  • Tony Rayner

Abstract

This paper investigates the claim that the common finding of cointegration between spot and lagged forward exchange rates reflects the existence of covered interest arbitrage and not, as is generally accepted, long-run market efficiency. Breuer and Wohar's (1996) methodology is employed to match spot and one-month forward rates correctly for three major currencies; the Deutschmark, Sterling and the Yen, relative to the US dollar. Bi-variate analysis shows that spot and lagged forward rates are cointegrated with the vector (1,-1), a necessary condition for market efficiency. However, at variance with theory, in a tri-variate VECM estimation, the spot rate, lagged forward rate and lagged interest rate differential are shown to be cointegrated with the vector (1,-1,1) for the Mark and Sterling. The 'cointegration' paradox is explained by investigating the relative magnitudes of the forecast error and the interest rate differential. It is demonstrated that it is impossible to distinguish between the influence of covered interest arbitrage and the existence of market efficiency using cointegration-based tests.

Suggested Citation

  • Neil Kellard & Paul Newbold & Tony Rayner, 2001. "Evaluating currency market efficiency: are cointegration tests appropriate?," Applied Financial Economics, Taylor & Francis Journals, vol. 11(6), pages 681-691.
    • Handle: RePEc:taf:apfiec:v:11:y:2001:i:6:p:681-691
    DOI: 10.1080/09603100010023113
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    References listed on IDEAS

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    1. Eric Zivot, 1998. "Cointegration and Forward and Spot Exchange Rate Regressions," Discussion Papers in Economics at the University of Washington 0069, Department of Economics at the University of Washington.
    2. Eric Zivot, 1998. "Cointegration and Forward and Spot Exchange Rate Regressions," Econometrics 9812001, University Library of Munich, Germany.
    3. Eric Zivot, 1998. "Cointegration and Forward and Spot Exchange Rate Regressions," Working Papers 0069, University of Washington, Department of Economics.
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    Cited by:

    1. Samih Antoine Azar, 2018. "Forward Unbiasedness in the Short End of the Interest Rate Market," International Business Research, Canadian Center of Science and Education, vol. 11(2), pages 70-78, February.
    2. Kellard, Neil & Sarantis, Nicholas, 2008. "Can exchange rate volatility explain persistence in the forward premium?," Journal of Empirical Finance, Elsevier, vol. 15(4), pages 714-728, September.
    3. Chigira, Hiroaki, 2006. "A test of serial independence of deviations from cointegrating relations," Economics Letters, Elsevier, vol. 92(1), pages 52-57, July.
    4. Kellard, Neil, 2006. "On the robustness of cointegration tests when assessing market efficiency," Finance Research Letters, Elsevier, vol. 3(1), pages 57-64, March.
    5. Nessrine Hamzaoui & Boutheina Regaieg, 2016. "The Glosten-Jagannathan-Runkle-Generalized Autoregressive Conditional Heteroscedastic approach to investigating the foreign exchange forward premium volatility," International Journal of Economics and Financial Issues, Econjournals, vol. 6(4), pages 1608-1615.
    6. Kang, Heejoon, 2008. "The cointegration relationships among G-7 foreign exchange rates," International Review of Financial Analysis, Elsevier, vol. 17(3), pages 446-460, June.

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