Analysing the efficiency in the foreign exchange markets of the Euro against American Dollar

Abstract

This paper tests the efficiency market hypothesis of the Euro/US Dollar currency pair in the foreign exchange market. The efficiency market hypothesis, developed by Eugene Fama, states that traders and investors cannot make abnormal profits on the basis of already available information. This is done by testing the month-end spot rate and 3-month forward rate for cointegration by using Engle Granger’s cointegration test. The null hypothesis that the spot rates and 3-month forward rates are efficient, is tested by first performing unit roots tests, namely the Augmented Dickey-Fuller test and Phillips-Perron test, on the residuals. Following the unit root tests, an empirical distribution test is performed to determine whether the residuals follow a normal distribution or a t-distribution which is important to determine which statistic to choose in the cointegration test. The final step is performing the Engle-Granger cointegration test on the variables. The result obtained from these tests successfully reject the null hypothesis that the variables are efficient, meaning that there is evidence against the efficient market hypothesis. This is because the cointegration tests suggests that there is an element of predictability in the exchange rates, implying that, with the use of technical analysis and other trading techniques, a trader or investor is capable of making abnormal profits when relying on available information.