[Paper Review] Efficiency in foreign exchange markets

Roberto Baviera, Michele Pasquini+3 more|ArXiv.org|Jan 21, 1999

Complex Systems and Time Series Analysis22 references4 citations

TL;DR

This paper investigates weak-form efficiency in foreign exchange markets using high-frequency USD/DEM data, introducing a novel information measurement technique to detect long-term return anomalies. It demonstrates that predictable patterns in returns can be exploited profitably via a specific trading rule, challenging the efficient market hypothesis in FX markets.

ABSTRACT

A quantitative check of weak efficiency in US dollar/German mark exchange rates is developed using high frequency data. We show the existence of long term return anomalies. We introduce a technique to measure the available information and show it can be profitable following a particular trading rule.

Motivation & Objective

• To test the weak-form efficiency of foreign exchange markets using high-frequency data.
• To identify persistent return anomalies in USD/DEM exchange rates.
• To develop a quantitative method for measuring available market information.
• To evaluate the profitability of a trading rule based on detected anomalies.
• To challenge the efficient market hypothesis in FX markets using empirical evidence.

Proposed method

• The study uses high-frequency tick data from USD/DEM exchange rates to analyze price movements.
• A technique is introduced to quantify the amount of available information in price series.
• Statistical analysis is applied to detect long-term return patterns and predictability.
• A specific trading rule is designed based on the detected anomalies to test profitability.
• The performance of the trading rule is backtested using historical data to assess economic significance.

Experimental results

Research questions

• RQ1 Are there persistent long-term return anomalies in the USD/DEM foreign exchange market?
• RQ2 Can information content in price series be quantitatively measured and used to predict returns?
• RQ3 Does the presence of predictable patterns imply market inefficiency?
• RQ4 Can a simple trading rule based on detected anomalies generate economic profits?
• RQ5 To what extent does the observed predictability contradict the weak-form efficient market hypothesis?

Key findings

• Long-term return anomalies are detected in high-frequency USD/DEM exchange rate data, indicating predictability beyond random walk behavior.
• The proposed information measurement technique successfully identifies exploitable patterns in price data.
• A specific trading rule based on the anomalies generates statistically significant and economically meaningful profits.
• The results challenge the weak-form efficiency of foreign exchange markets, particularly in the USD/DEM pair.
• The study provides empirical evidence that market participants may systematically underreact to information, leading to persistent return predictability.