NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Re-Interpreting the Failure of Foreign Exchange Market Efficiency Tests:Small Transaction Costs, Big Hysteresis Bands

Richard E. Baldwin

NBER Working Paper No. 3319
Issued in April 1990
NBER Program(s):International Trade and Investment, International Finance and Macroeconomics

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 misspecified. 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.

download in pdf format
   (395 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w3319

Users who downloaded this paper also downloaded* these:
Lewis w4951 Puzzles in International Financial Markets
Bilson w0474 The "Speculative Efficiency" Hypothesis
Meredith and Chinn w6797 Long-Horizon Uncovered Interest Rate Parity
Baldwin w2911 Sunk-Cost Hysteresis
Chinn and Frankel w3807 Patterns in Exchange Rate Forecasts for 25 Currencies
 
Publications
Activities
Meetings
NBER Videos
Themes
Data
People
About

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us