Market Efficiency Concepts

The theoretical concepts of informational and speculative market efficiency are closely related to the IRP Theorem. According to [124] and [126], a financial market is said to be (informationally) efficient, if prices in that market fully reflect all the available and relevant information. The intuition is, that, if the market processes that information immediately, price changes can only be caused by the arrival of new information. However, since future information cannot be predicted, it is also impossible to predict future price changes. Depending on the information set available, there are different forms of the market efficiency hypothesis (MEH).

• Weak-form efficiency. No investor can earn excess returns by developing trading rules based on historical price or return information. In other words, the information in past prices or returns is not useful or relevant in achieving excess returns.

• Semistrong-form efficiency. No investor can earn excess returns by developing trading rules based on publicly available information. Examples of publicly available information are annual reports of companies, investment advisory data, or ticker tape information on TV.

• Strong-form efficiency. No investor can earn excess returns using any information, whether publicly available or not. In other words, the information set contains all information, including private or insider information.

If applied to the foreign exchange markets, informational efficiency means that the current spot rate has to reflect all currently available information. This has one important implication: if expectations about the future exchange rate are rational [304] they should all be incorporated in the forward rate. Hence, if the efficient market hypothesis holds true, the forward rate must be an “unbiased predictor” for the expected exchange rate ([137]). When the forward rate is termed an unbiased predictor, then it over or underestimates the future spot rate with relatively equal frequency and amount. It therefore misses the spot rate in a regular and orderly manner such that the sum of the errors equals zero. As a direct consequence, it is not possible to make arbitrage profits since active investment agents will exploit any arbitrage opportunity in a financial market and thus will deplete it as soon as it may arise. Empirical tests for a bias in forward rates have been based on testing the two principles of CIA and UIA which have been referred to in Sect. 3.2.