Predictability and ‘Good Deals’ in Currency Markets

Abstract

This paper studies predictability of currency returns over the period 1971-2006. To assess the economic significance of predictability, we construct an upper bound on the explanatory power of predictive regressions. The upper bound is motivated by “no good-deal” restrictions that rule out unduly attractive investment opportunities. We find evidence that predictability often exceeds this bound. Excess-predictability is highest in the 1970s and tends to decrease over time, but it is still present in the final part of the sample period. Moreover, periods of high and low predictability tend to alternate. These stylized facts pose a serious challenge to Fama’s (1970) Efficient Market Hypothesis but are consistent with Lo’s (2004) Adaptive Market Hypothesis, coupled with slow convergence towards efficient markets. Strategies that attempt to exploit excess-predictability are very sensitive to transaction costs but those that exploit monthly predictability remain attractive even after realistic levels of transaction costs are taken into account and are not spanned either by the Fama and French (1993) equity-based factors or by the AFX Currency Management Index.