A Literature Review of the Efficiency of the Foreign Exchange Market

EC7075: International Money & Finance

NOTE: Please contact us for a customized academic paper


Kallianiotis (2017) explains that foreign exchange (FOREX) market efficiency hypothesis proposes that prices reflect fully the information available to parties concerned, and as such, there are no loopholes to make excessive profits. Additionally, the literature on FOREX market efficiency is based on three types of efficiencies which include. First, the weak form which assumes that the current price fully reflects information that is contained in historical prices. Second, the semi-strong form which assumes that the present price fully reflects information available to the public such as employment rate. Third, the strong form which posits that the present price incorporate all known information.

For several decades, the efficiency of this market has been supported and opposed in equal measures. Moreover, the empirical evidence portrays without a doubt that this issue is far from being settled. As such, this literature review will way both sides of literature addressing efficiency of the FOREX market and in order to achieve its objective four models will be applied. They include the Random Walk Hypothesis (RWH), Uncovered Interest-rate Parity (UIP), the Forward Rate Unbiasedness Hypothesis (FRUH) and the filter rule.

Theories to test foreign exchange market efficiency

The Random Walk Hypothesis (RWH)

Kallianiotis (2018) concedes that most research on efficient markets was earlier based on this hypothesis. RWH states that price changes happens randomly and are uncorrelated. As such, if currencies returns are unpredictable and thus random, exchange rate markets are said to be efficient. Against this background, one method applied to test efficiency is by studying how random the exchange rates fluctuate.

In this vein, Akel et al. (2015) carried out a study to examine if the Turkish FOREX market was in consonance with RWH. To achieve their objective the scholars applied ADF and Phillips-Peron test, and studied the local currency against the USD rates from 2000 to 2013. Their result concluded that the Turkish market was inefficient. Conversely, a study by Firoj and Khanon (2018) aimed to investigate Banglandesh’s market efficiency. To achieve this, they used seven major currencies against the local currency. The study highlighted that all of the exchange rates validated the RWH and thus indicating weak form of market efficiency but no indication of semi-strong efficiency.   

Similarly, Amelot et al. (2017) test the efficiency of Mauritius FOREX market using EUR, USD, GBP and JPY against the local currency. They studied data from 2012 to 2016 and like Akel et al. (2015) used PP root test and ADF. Their study concluded that the Mauritius market was efficient (weak form) as it followed RWH. Moreover, in Europe an extensive study was carried out by Charles and Darne (2009) the results indicated that exchange rates based in Euro for main trading partners such as Canada, U.S and Japan follow RWH and are as such Weak form efficient. However, the result differed with currencies from minor trading partners and mostly so, the Swedish (Kroner), where the rates did not follow RWH. Additionally, the study noted that efficiency realised with main trading partners was not confirmed for daily prices but for weekly prices for Norway which suggested that it was likely to get abnormal profits on the short term.

Despite the RWH being applied to test the FOREX market efficiency it has some shortcomings which may be the reason for different results as noted in above empirical studies. The main shortcoming of this hypothesis is that it does not take into account market trends and other vital factors that have significant effects on the prices (Hiremath and Narayan, 2016). In the same vein, several scholars contends that prices are affected by trends that are mostly difficult to pinpoint and may take huge amount of data and analysis to do so, but failure to identify these trends does not mean that they do not exist.   

Uncovered Interest Rate Parity (UIP)

This theory posits that interest rates difference between two nations will over the same period equal to relative change in the currency foreign exchange rates (Cuestas et al., 2015). If the theory holds, no arbitrage opportunity occurs and as such no abnormal returns can be earned. Further on, this theory assumes that the country with higher interest rate among the two countries will have a depreciation of it currency relative to the other country’s currency. Some empirical studies used to test efficiency using this theory include. To start with, Czech and Waszkowski (2012) aimed to assess the efficiency of USD/EUR foreign exchange market. They applied conventional UIP regression technique. Their results showed that the market was efficient, and the slope coefficient occurred as negative which implied UIP failure. However, the scholars found no base to reject UIP hypothesis during the last financial crisis. Moreover, the study rejected semi-strong and strong efficiency of the market. The scholars concluded that UIP works better during crises, and that the rejection of foreign exchange market efficiency occurs due to flowed assumption that traders have rational expectation and are risk neutral.    

Similarly, Cuestas et al. (2015) examined validity of UIP hypothesis using data of 5 Central and Eastern European countries. The result of the research showed that when market participants had rational expectations, the UIP hold. This implied that traders could not expect excess risk-adjusted returns from investing in assets that are dominated in one currency or the other. Conversely, when market participants had static expectations, a deviation form UIP was experienced in their study for at least some time of the studied duration. In this case, lack of empirical support for UIP may provide arbitrage opportunities for investors with static expectations. This study clearly shows that expectations are vital for results when UIP is tested empirically. The same conclusion was reached by Czech (2017) who aimed to test UIP in Poland Zloty/ Japanese Yen foreign exchange market. The results showed that during low volatility anomaly appears, while during high volatility UIP succeeds.   

Despite this model being prominent among analysts, it has some limitations. To start with, based on the above analysis it is clear that UIP holds and fails as a result of uncertainty as it requires assumption of efficient market which in reality is not practical (Lidawati et al., 2016). Additionally, empirical studies has highlighted that over short and also medium terms, the lower yielding currency has most of the times weakened but not strengthened. Moreover, empirical evidence has established that depreciation expected rate, which has vital role in UIP is at most times less than difference which requires to be adjusted. This shortcoming hinders UIP from working efficiently. Against this backdrop, most empirical research indicates that UIP does not hold. However, market participants still rely on it as it is convenient during model building to represent rational expectations.

The Forward Rate Unbiased Hypothesis (FRUH)

This hypothesis asserts that during rational expectations among market participants and times of risk neutrality there ought to be between forward rate and corresponding future spot rate a one-on-one relationship (Makovsky, 2014). However in reality, cointegration-based tests to test this hypothesis have produced contradicting results. For example, Kang (2019) aimed to establish whether the Korean foreign exchange market is efficient using FRUH. The research concluded that the market was not very efficient during 2006-2016 but improved after the financial crisis from specifically from 2010. As a result, market inefficiencies highlighted arbitrage opportunities in the foreign exchange and derivatives markets. Moreover, the study concluded that the country’s central bank had fostered formation of inefficiencies.

Similarly, Cicek (2014) examined efficiency of the Turkish market using FRUH by studying USD against the local currency using cointegration method. The research found out that the market was weak efficient but semi-strong inefficient. Moreover, the study concluded that the Turkish Lira against USD market adjusted more quickly towards the equilibrium, and forward rates could be used more to understand spot rates movements in comparison with the Lira/ EUR market. Lastly, Kallianiotis (2018) aimed to study the efficiency of developing and developed foreign exchange market. The study showed that during “booms” periods that are characterised by less volatility and more appetite for risk, developed and developing markets are efficient. Conversely, when markets deteriorates, appetite for risks decreases and thus, currencies from developed countries are perceived to be safe-haven while those from developing countries are perceived to be risky. As a result of this change in perception, developing FOREX markets are more inefficient in times of tensions as the study showed by rejection of RWH. However, developing market was portrayed as efficient when tested using FRUH.

Although FRUH has been used as a test of foreign exchange market efficiency, it has been criticised by researchers due to some shortcomings. To start with, Kallianiotis (2018) puts forth this model has often proved to hold in developed countries market, but not appropriate for developing countries. This assertion is in consonance with Johannes and Makabeng (2014) submission that due to lack of well-developed financial systems and interference of the systems by the governments, developing countries may have highly regulated forward rates and as such are in appropriate to test market efficiency. Moreover, these countries do not have forward market and forward rates are often not available. In sum, most researchers conclude that in most cases, empirical research indicates that forward rates are not efficient and reliable forecasts to determine spot rates in the future. Nevertheless, market participants apply this technique along with others to better understand the changes in prices in the market.

The filter rule

This is a model of testing efficiency where an analyst set rules in order to identify buy and sell opportunities based on percentage changes of prices (Lee and Sodokhuu, 2012). Additionally, this rule is based on price movements or the idea that prices that are on the rise will continue to do so, and prices on decline will continue falling. As a consequence, when the price rises to a certain percentage, it signals a buy, whereas a certain percentage decline signals a sell. In an efficient market this technique does not produce excessive returns. Several studies have been carried out to test market efficiency applying this rule. Most notably, Lee and Sodokhuu (2012) aimed to examine foreign exchange market efficiency by testing EUR, JPY and GBP performance. The results established that investor would get more profit by using buy long/ sell short filter rule strategy when not taking into account the cost of transaction. However, transaction of the three exchange rates would be more efficient by taking into account the cost of transaction. These results signified that the FOREX market is efficient for the three currencies. Moreover, the result of the study concluded that South Korea and Japanese markets are efficient (weak form), whereas Taiwan’s is inefficient.

Although the filter rule is common among analysts, this model has some limitations. For example, Agbola et al. (2015) sustain that the main limitation of this model as a test of market efficiency is the lack and/ or difficult of getting data. The scholar contends that to test the validity of this rule, analysts require actual interest rates and actual prices from simultaneous foreign exchange transactions. However, daily exchange and interest rates are often available to analysts for a short time frame that is not enough for conclusive results.


By theoretical and empirical analysis, this review delved in the foreign exchange market to test its efficiency. Focusing on four theoretical models, the findings indicate that most of the time, theory often assumes that the market is efficient, that is, prices are a fully reflection of their fundamental values. However, in reality, empirical evidence suggests that there are information asymmetry and other factors such as government interference and black markets that results to markets being inefficient.  How inefficient this market is is still debatable since any anomaly in pricing can be viewed by market participants in a rational way. In the same vein, this review contends that this debate about whether or not the foreign exchange market is perfectly efficient is not worth it, and evaluating the extent of market inefficiency would be more helpful to traders.


Agbola, F.,  Katusiime, L., and Shamsuddin, A. (2015). ‘Foreign exchange market efficiency and profitability of trading rules: Evidence from a developing country.’ International Review of Economics and Finance, 35(1), 315–332.

Akel, L., Cetin,M., and Citak, L. (2015). ‘Testing Random Walk Hypothesis in Turkish Foreign Exchange Market.’ Review of Economic and Business Studies, 10(1), 103-125.

Amelot, L., Lamport, M. and  Ushad, S. (2017).  ‘Testing the Efficient Market Hypothesis in an Emerging Market: Evidence from Forex Market in Mauritius.’ Theoretical Economics Letters, 7, 2104-2122

Charles, A. and Darne, O. (2009). ‘Testing for random walk behaviour in Euro exchange rates.’ International Economics, 3(119), 24-45

Cicek, M. (2014). ‘A COINTEGRATION TEST FOR TURKISH FOREIGN EXCHANGE MARKET EFFICIENCY.’ Asian Economic and Financial Review, 4(4), 451-471

Cuestas, J.,  Filipozzi, F. and Staehr, K. (2015): Uncovered Interest Parity in Central and Eastern Europe: Sample, Expectations and Structural Breaks [Online] Available at: file:///C:/Users/user/Downloads/paper_2015014.pdf (Accessed on 23rd April 2020).


Czech, K. and  Waszkowski, A. (2012): FOREIGN EXCHANGE MARKET EFFICIENCY. EMPIRICAL RESULTS FOR THE USD/EUR MARKET [Online] Available at: https://core.ac.uk/download/pdf/25968326.pdf (Accessed on 23rd April 2020).

Firoj,M and Khanom,S. (2018). ‘Efficient Market Hypothesis: Foreign Exchange Market of Bangladesh.’ International Journal of Economics and Financial Issues, 8(6), 99-103.

Hiremath, G. and Narayan, S. (2016). ‘Testing the adaptive market hypothesis and its determinants for the Indian stock markets.’ Finance Research Letters, 19, 173–180.

Johannes, P. and Mabakeng, M. (2014). ‘Examining the weak form efficiency in foreign exchange market in Namibia.’ International Review of Research in Emerging Markets and the Global Economy, 1(4), 174-187.

Kallianiotis, I. (2017). ‘Exchange Rate Movement: Efficiency in the Foreign Exchange Market.’ International Research Journal of Applied Finance, 8(4), 195-213.

Kallianiotis, I. (2018). ‘How Efficient is the Foreign Exchange Market?Athens Journal of Business & Economics, 4(3), 293-326.

Kang, M. (2019).  ‘Currency Market Efficiency Revisited: Evidence from Korea.’ International. Journal of Financial Studies 7(3), 52

Lee, H. and sodokhuu, K. (2012). ‘Efficiency Tests in Foreign Exchange Market International Journal of Economics and Financial Issues, 2(2), 216-224

Lindawati, S., Putra, A. and Sari, H. (2016). ‘Are The ASEAN-5 Foreign Exchange Markets Efficient? Evidence from Indonesia, Thailand, Malaysia, Singapore, and Philippines: Post-Global Economic Crisis 2008.’ Indonesian Capital Market Review 8 (2016) 83-93

Makovský, P. (2014). ‘Modern approaches to efficient market hypothesis of FOREX–the central European case.’ Procedia Economics and Finance, 14, 397-406.