Currency Derivatives and Exchange Rate Forecastability

By incorporating new information generated by currency derivatives trading, underlying exchange rates should be less forecastable than previously and the underlying currency markets should, therefore, be more efficient. This hypothesis was tested, for the first time, for the period 1982 through 1997 on a clean sample of three major types of currency derivatives launched in two prominent markets. Various statistical tests indicate that following the introduction of the derivative contracts, the underlying exchange rates became more random and the currencies involved tended thus to be priced more efficiently, which supports the hypothesis.The Chicago Mercantile Exchange (CME) introduced currency futures in 1972, and the Philadelphia Stock Exchange (PHLX) pioneered option trading on major currencies in 1982. Derivatives trading on currencies has attracted interest from academics, practitioners, and regulators, as documented in existing studies. So far, studies have focused on the impact of derivatives trading on the volatility of spot exchange rates, and the results have been mixed. No study has examined the impact of derivatives trading on the pricing efficiency in the underlying currency market, which is an important market quality, or the impact of derivatives trading on the forecastability of underlying exchange rates, a characteristic of enormous importance to market participants.When derivatives trading commenced, pricing efficiency of underlying exchange rates could have been enhanced through a number of conceivable channels. First, prior to the CME initiation of currency futures, the bulk of currency trading was in London time; any London overnight move tended to wash out on the next trading day in London. The CME market should thus have improved liquidity in the U.S. time zone and, therefore, improved market liquidity and efficiency around the clock. Second, enormous growth has occurred in OTC currency derivatives since the early 1970s, when major currencies began to float. It has been claimed that the creation of currency futures was instrumental in encouraging the rapid expansion of OTC trading and, in turn, in ameliorating the pricing efficiency in the underlying markets. Third, the advent of exchange-traded currency derivatives should have reduced nonrandom runs or clustering in the exchange rates and, therefore, increased market efficiency because currency market participants had previously been forced to pursue trend-following strategies (portfolio insurance) to protect themselves against adverse moves in exchange rates. Fourth, the introduction of currency options made the market more complete and, therefore, more efficient because the second moment (volatility) of the exchange rate distribution became directly priced. Finally, formal models of rational expectations predict higher pricing efficiency in an underlying market when derivatives are listed because of increased information flow.The intention of this study was to investigate for the first time the effect of derivatives trading on pricing efficiency in the underlying currency market. I used a clean sample of currency derivatives launched by the CME and the PHLX from 1982 to 1997. A major advantage of using these currency derivatives is that multiple major derivative contracts, including futures, options, and futures options, on the same currencies were often introduced simultaneously. Such intensive and comprehensive listings presented a unique opportunity to test the efficiency effects of derivatives trading and thus deliver a robust verdict on the hypothesis presented earlier.Using a nonparametric runs test, I found that following the derivatives listings, returns to the sample currencies, on average, become significantly more random. This increased randomness was also detected in two robustness tests. This finding suggests that, to the extent that randomness proxies for efficiency, efficiency increased in the spot market following the commencement of derivatives trading. Moreover, the increased randomness meant decreased predictability in exchange rates, an implication of interest to market participants.