Technical Trading, Predictability and Learning in Currency Markets

Abstract

This paper studies predictability of currency returns over time and the extent to which it is captured by trading rules commonly used in currency markets. We consider the strategies that an investor endowed with rational expectations could have pursued to exploit out-of-sample currency predictability and generate abnormal returns. We find a close relation between these strategies and indices that track popular technical trading rules, namely moving average cross-over rules and the carry trade, implying that the technical rules represent heuristics by which professional market participants exploit currency mispricing. We find evidence that such mispricing reflects initially wrong investors’ beliefs (wrong priors), but information is efficiently processed as it becomes available. Predictability is highest in the mid ’90, subsequently decreases sharply, but increases again in the final part of the sample period, especially for the Euro and other emerging currencies.