Model-free evaluation of directional predictability in foreign exchange markets, страница 3

Ultimately, it is an empirical issue whether the direction of foreign exchange rate changes is predictable. All technical trading rules are built on a fundamental assumption; i.e., the pattern of the foreign exchange market is regular and can be repeated. Indeed, technically oriented forecasts are generally more accurate in predicting the direction of changes in the exchange rates than economic structural models (e.g., Cumby and Modest, 1987; Somanath, 1986). Considerable evidence in the literature suggests that these rules may generate significant profits in the foreign exchange market. Examples include Dooley and Shaffer (1983), Sweeney (1986), and Levich and Thomas (1993) for the use of filter rules, Lee and Mathur (1996) and LeBaron (1999) for the use of moving average trading rules, and Neely and Weller (1999) for the use of genetic programming. Some speculations suggest that the directions of foreign exchange rate changes are predictable by anticipating monetary policies: the monetary authorities might use foreign exchange market intervention as a means of monetary policies (rather than merely as an instrument for exchange rates stability) to achieve and strengthen major macroeconomic goals, such as high employment, low inflation, economic growth, trade balance, and price stability. In fact, several studies suggest that the monetary authorities may actually intervene to signal future monetary policies (e.g., Carlson et al., 1995; Mussa, 1981). Thus, once the speculators realize the expected future stance of monetary policies, they are able to exploit potential gains from the aforementioned intervention by correctly following the direction of the short-run trend (e.g., Baillie and Osterberg, 1997; Bonser-Neal and Tanner, 1996; Dominguez and Frankel, 1993; Ghosh, 1992).

There is a growing consensus that real and nominal exchange rates exhibit mean reversion toward the equilibrium level implied by economic fundamentals (e.g., Abuaf and Jorion, 1990; Frankel and Rose, 1996b; Jorion and Sweeney, 1996; Lothian and Taylor, 1996).^[2] More interestingly, the degree of mean reversion is stronger when the deviation of actual exchange rates from the equilibrium is greater (e.g., Taylor and Peel, 2000; Taylor et al., 2002). The role of transaction costs has been central to theoretical models of explaining this nonlinearity. For instance, Dumas (1992) and Sercu et al. (1995) suggest that transaction costs produce ‘a band of inaction’ within which international price differentials incur no arbitrage. Similarly, due to friction and political costs, it is natural to expect greater intensity of market intervention when a substantial deviation is observed and expected to continue (Ito and Yabu, 2004). Consequently, the adjustment process takes place only when the perceived misalignment is large enough to cover such costs.^[3] An alternative viewpoint can be discerned from the exchange rate behavior postulated by the target zone model (Krugman, 1991). In an exchange rate target zone, the monetary authorities allow exchange rates to float freely within the zone. However, if the rates approach the edge, i.e., upper or lower limits of the zone, they actively intervene in the foreign exchange market. In this framework, the exchange rates follow a bounded process and thereby exhibit mean reversion within the zone (see Anthony and MacDonald, 1998, 1999, for empirical evidence of this implication). Again, these findings may provide another strand of evidence that supports directional predictability in foreign exchange markets. In the presence of (nonlinear) mean reversion of exchange rates, it is intuitively plausible that the direction of foreign exchange rate changes is predictable from monetary fundamentals. That is, when the domestic interest rate is significantly higher than foreign interest rates or when the domestic inflation rate is significantly lower than foreign inflation rates, appreciation of the domestic currency is anticipated because of exogenous realignment pressures (i.e., market intervention) or endogenous realignment pressures (i.e., market forces to bring the rates back to the equilibrium), which are inherited by a mean reversion process. Therefore, we are at least able to predict the direction of future foreign exchange rate changes, even if it is difficult to predict the level of the exchange rate changes using economic fundamentals.