Re-Interpreting the Failure of Foreign Exchange Market Efficiency Tests:Small Transaction Costs, Big Hysteresis Bands
Richard E. Baldwin
Small transaction costs and uncertainty imply that optimal cross-currency interest rate
speculation is marked by a first-order hysteresis band. Consequently uncovered interest
parity does not hold and market efficiency tests based on it are miaspecified. Indeed
measured prediction errors are a combination of true prediction errors and a wedge that
consists of the "option value" of being in foreign currency and either plus or minus the
transaction cost. Due to the nature of this wedge, we should expect measured prediction
errors to be serially correlated, correlated with the current forward rate and perhaps have a
non-zero mean, if the interest differential itself is serially correlated. The existence of the
wedge helps account both for the failure of market efficiency tests and the difficulties in
finding an empirically successful model of the risk premium.
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