What Drives Currency Predictability?

52 Pages Posted: 8 Oct 2012 Last revised: 24 Aug 2022

See all articles by Valerio Potì

Valerio Potì

University College Dublin

Akhtar R. Siddique

Government of the United States of America - Office of the Comptroller of the Currency (OCC)

Date Written: March 22, 2013

Abstract

In this paper, we study predictability of exchange rates and explore determinants of its dynamics over time. We model the admissible amount of predictability in two ways, each corresponding in a stylized manner to a broad class of rational currency pricing models, namely those under which the marginal currency trader can diversify away currency risk and alternative specifications under which this possibility is precluded. Under the null of Rational Expectations, we find strong evidence against the former class of models but little evidence against the latter, except that predictability itself is predictable. Our results pose a challenge to Fama’s (1970) Efficient Market Hypothesis, but are consistent with microstructure models of foreign exchange markets in which a capital-constrained undiversified marginal currency trader seeks reward for total risk instead of systematic risk alone and sluggish risk capital mobility drives predictable time-variation in currency predictability.

Keywords: Foreign Exchange, Predictability, Market Efficiency

JEL Classification: F31

Suggested Citation

Potì, Valerio and Siddique, Akhtar R., What Drives Currency Predictability? (March 22, 2013). Available at SSRN: https://ssrn.com/abstract=2158348 or http://dx.doi.org/10.2139/ssrn.2158348

Valerio Potì (Contact Author)

University College Dublin ( email )

M. Smurfit School of Business
Carysfort Avenue, Blackrock
Dublin, Co Dublin
Ireland

HOME PAGE: http://https://people.ucd.ie/valerio.poti

Akhtar R. Siddique

Government of the United States of America - Office of the Comptroller of the Currency (OCC) ( email )

400 7th Street SW
Washington, DC 20219
United States

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