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Foreign exchange market efficiency and cointegration

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  • Montserrat Ferre
  • Stephen Hall

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.

Suggested Citation

  • Montserrat Ferre & Stephen Hall, 2002. "Foreign exchange market efficiency and cointegration," Applied Financial Economics, Taylor & Francis Journals, vol. 12(2), pages 131-139.
    • Handle: RePEc:taf:apfiec:v:12:y:2002:i:2:p:131-139
    DOI: 10.1080/09603100110090055
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    2. Kühl, Michael, 2008. "Strong comovements of exchange rates: Theoretical and empirical cases when currencies become the same asset," University of Göttingen Working Papers in Economics 76, University of Goettingen, Department of Economics.
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    4. Kühl, Michael, 2007. "Cointegration in the foreign exchange market and market efficiency since the introduction of the Euro: Evidence based on bivariate cointegration analyses," University of Göttingen Working Papers in Economics 68, University of Goettingen, Department of Economics.
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    6. Kühl, Michael, 2010. "Bivariate cointegration of major exchange rates, cross-market efficiency and the introduction of the Euro," Journal of Economics and Business, Elsevier, vol. 62(1), pages 1-19, January.

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