Dissertation Final

Can Technical Analysis Disprove the Efficient Market Hypothesis? A Foreign Exchange Example.
Clare Dixon
BSc Economics 2005
I certify that this thesis and the research to which it refers, are the product of my own work, and that any ideas or quotations for the work of other people, published or otherwise, are fully acknowledged in accordance with standard referencing practices of the discipline. I also state that this work is to be made freely available for photocopying and inter-library lending.
Clare Dixon
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0 - Abstract
Technical analysis is the use of past price actions, to guide future trading decisions in asset markets. Technical Analysis attracts the attention of economists as its successes cast doubt upon the Efficient Market Hypothesis (EMH) which states that market prices instantaneously and fully reflect all relevant information and therefore, that asset timeseries follow a random walk. EMH holds that publicly available information, such as past prices, should not assist traders in earning unusually high returns. We study five years of data across five currency pairs. Using Dickey-Fuller and KPSS unit root tests we establish that our data series seem to follow a random walk as suggested by the Efficient Market Hypothesis. We then test three commonly used technical trading techniques, moving averages, filter rules and Relative Strength Indices. We find them, in the main, to be unprofitable, particularly after the inclusion of transaction costs. Finally we note a psychological tendency for people to see patterns in random series of data, suggesting that it is perhaps unsurprising that traders place such weight on technical analysis. We do however note that due to the paradox of efficient markets is seems unlikely that asset markets are perfectly efficient.
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Contents
Abstract List of Abbreviations Acknowledgements 1 Introduction 2 The Efficient Market Hypothesis 3 Technical Analysis 3.1 Principles of Technical Analysis 3.2 - Technical Analysis Techniques: Charting 3.3 Technical Analysis Techniques: Mechanical Rules 4 Evaluating the Random Walk 4.1 The Data 4.2 Stationarity and Random Walks 4.3 The Dickey-Fuller unit root test 4.4 The Kwiatkowski-Phillips-Schmidt-Shin (KPSS) test 4.5 Results and Analysis 5 Evaluating Technical Analysis 5.1 The Tests 5.2 Results and Analysis
iii vi vii 1 3 8 9 10 13 17 17 17 19 20 22 24 24 25 iv
5.3 Limitations of the Analysis 5.4 This Analysis and Other Research 6 Further Considerations 6.1 Central Bank Intervention 6.2 The Representativeness Heuristic 6.3 The Paradox of Efficient Markets 7 Extensions 8 Conclusions References Bibliography Appendix A Constructing the Dickey-Fuller test Appendix B The Dickey-Fuller unit root test outputs Appendix C Calculating the RSI
30 31 33 33 34 35 37 38 40 46 47 53 57
List of Abbreviations
EMH - Efficient Market Hypothesis FX Foreign Exchange / Forex OLS Ordinary Least Squared RSI Relative strength Index MA Moving average GBP Great British Pound USD United States Dollar CHF Swiss Franc CAD Canadian Dollar JPY Japanese Yen EUR Euro DSP Difference Stationary Process TSP Trend Stationary Process SETS - Stock Exchange Electronic Trading Service
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Acknowledgements
I would like to thank all the individuals on the Lehman Brothers Foreign Exchange Desk, for data, inspiration, and employment; Alex Mandilaras for his advice and support; my housemates for going away for long enough to allow me to write this and Simon Pearson for coming back just in time to poof read. However, I dedicate this project in its entirety to Threshers, fine purveyors of bottled inspiration.
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1 - Introduction
It was Charles Henry Dow (1985-1902), founder of the Wall Street Journal and Dow Jones and Company who first formalised the theory that past prices could be used to guide future investment decisions. His early work gave rise to a number of theories and techniques which are now employed globally by investors to inform their trading decisions. However, these theories have always been treated by economists with both skepticism and disdain. Malkiel in his 1982 text, A Random Walk Down Wall Street stated: Obviously I am biased against the chartist. This is not only a personal predilection, but a professional one as well. Technical Analysis is anathema to the academic world. We love to pick on it. Our bullying tactics are prompted by two considerations: the method is patently false; and its easy to pick on. And while it may seem a bit unfair to pick on such a sorry target, just remember it is your money we a trying to save. Technical Analysis specifically attracts the attention of economists as its successes cast doubt upon the Efficient Market Hypothesis (EMH) which states that market prices instantaneously and fully reflect all relevant information. The EMH maintains that publicly available information, such as past prices, should not assist traders in earning unusually high returns. Technical Analysis on the other hand suggests that economic fundamentals, such as interest rates and growth are not always the sole determinant of the exchange rate, rather that it is driven away from its fair value by traders irrational expectations of future exchange rate movements.
In this project I intend to establish whether the Efficient Market Hypothesis is representative of the foreign exchange market using both primary and secondary research. I will consider the work of several authors, whilst also conducting two experiments of my own. The first will test the hypothesis that markets are weak form efficient using econometric techniques to establish whether a history of FX rates follow a random walk. The second will test the profitability of some simple technical analysis techniques.
2 - The Efficient Market Hypothesis

If one were to state that market prices instantaneously and fully reflect all relevant information available, one would be discussing the Efficient Market Hypothesis. Should this statement prove to be true then the market price of a security will always reflect its fair or fundamental value, or be sufficiently close to it to negate the possibility of exploiting any difference profitably given transaction costs. In other words past prices should provide no information about future prices that would allow an investor to earn excess returns, over a passive-buy-and-hold strategy, from using active trading rules based on historical prices. As such EMH categorically refutes the possibility of obtaining excess returns from technical analysis. So what is the Efficient Market Hypothesis? It is common in discussion of the Efficient Market Hypothesis, as exemplified by Blakes1 text, to consider the Fair Game model. In the Fair Game Model there is no systematic difference between the actual return on the game and the expected return before the game is played. As in equation 2.1 the returns in the next period are the expected returns for the next period dependant upon information available in the current period (denoted t ), plus the prediction error at time t +1. (2.1)
ri ,t +1 = E (ri ,t +1 / t ) + i ,t +1
Rather than being ignored, as in some economic theory, the prediction error is integral to this analysis. The error in predicting future returns (
1
i ,t + 1
) is deemed a white noise.
Blake. D., 2000. Financial Market Analysis. Second Edition, John Wiley & Sons, Chichester
The term white noise refers to a series with an expected value of zero, a variance of 2 , and an autocovariance of zero. As such, this error has three primary statistical properties, consistency, independence and efficiency. The prediction error is deemed to be consistent or unbiased if its expected value, conditional on t , is zero (see equation 2.2). This essentially states that asymptotically the mean error will be zero. (2.2)
E ( i ,t +1 / t ) = E (ri ,t +1 E (ri ,t +1 / t ) / t ) E ( i ,t +1 / t ) = E (ri ,t +1 / t ) E (ri ,t +1 / t ) E ( i ,t +1 / t ) = 0
Secondly independence dictates that the prediction error is uncorrelated with the expected return in the same period (see equation 2.3) (2.3) E ( i ,t +1 E (ri ,t +1 / t ) / t ) = E (ri ,t +1 / ) E ( i ,t +1 / ) We know from 2.2 that E ( i ,t +1 / t ) = 0 , therefore E ( i ,t +1 E (ri ,t +1 / t ) / t ) = 0
Finally the prediction error will be efficient if it is both contemporaneously and serially uncorrelated. As such, the following three equations must hold. Equation 2.4 states that the prediction error for security i, will be contemporaneously uncorrelated with the prediction error for security j. (2.4) 2 E ( i ,t +1 j ,t +1 / t ) = 0
where i and j represent different securities.
Equation 2.5 states that the prediction error for security i, is uncorrelated with that in the previous period. (2.5) E ( i ,t +1 i ,t / t ) = 0
Equation 2.6 determines that i is also uncorrelated with the prediction error for security j in the previous period. (2.6) E ( i ,t +1 j ,t / t ) = 0
If any of these conditions were not to hold then it would be possible to improve the prediction of returns using a simple mechanical rule (i.e. technical analysis). Given that we have taken time to consider the prediction error we should also consider how individuals form their expectations of future prices. The EMH can again provide some insight. We should note that if EMH is a reasonable representation then markets will be in a continuous stochastic equilibrium, i.e. securities will always equal their fair or fundamental values, and any change in the fundamental value will be reflected immediately in the market price. As such, the only factor which could alter the fundamental value of a security would be new information. Without any additional information we would not expect there to be any change in the value of the security. However, news is by definition unpredictable and random, otherwise it is not news. As such, movements in the value of a security will also be unpredictable and random. News from one day to the next will affect the securitys price in varying directions and by varying magnitudes. It follows therefore that movements in the securitys value can be described as a white noise. To clarify let us consider a toy company. Today we could hear that the company has been given exclusive rights to produce the new Harry Potter action figures. This would be a lucrative deal for the company and as such one would expect their share price to rise. However the next day there could be an explosion on a major oil rig, raising the price of
oil and the cost of the plastic used to produce the dolls, causing a fall in the share price. In both cases the news is unpredictable, while having a noteworthy impact upon the securitys value. As Blake points out in his text, this analysis implies that the superlative estimator of the return on the security tomorrow, would be the return on the security today. This is because even though tomorrows return will almost certainly differ from todays, it will differ in a way that is completely unpredictable. As such if EMH holds we would expect that: (2.7) E (ri ,t +1 / ) = ri ,t
Substituting into equation (2.1) we obtain (2.8) ri ,t +1 = ri ,t + i ,t +1
Equation 2.8 is known as a random or drunken walk. It states that the value of a security tomorrow is dependant upon todays value plus a prediction error determined by new information (unpredictable given todays information set t ) generated between today and tomorrow. The Efficient Market hypothesis is generally expressed in three separate forms as refined by Jensen (1978); Weak, Semi-strong and Strong. 1) Weak-form EMH suggests that current security prices instantaneously and fully reflect all information contained in the past history of security prices. That is to say, past prices provide no information about future prices that would allow an investor to earn excess returns (over a passive buy-and-hold strategy) from using active trading rules based on historical prices.
2) Semi-strong EMH states that security prices instantaneously and fully reflect all publicly available information about the securities market. As such when new information is made public, it is rapidly incorporated into a securitys price. 3) Strong-form EMH states that current security prices instantaneously and fully reflect all known information about the securities markets including that which is privately available (inside information). This implies that the markets respond so quickly, that even someone with the most valuable piece of information would be unable to trade profitably upon it. Fama (1970) examined weak, semi-strong and strong EMH finding that with a few exceptions the efficient markets model stands up well. Then Fama (1991), in a sequel to his initial work, found, using event studies, that prices react quickly to new information. He also suggested that while private information afforded traders excess returns that such information was rarely obtained. Moorthy (1995) found, using foreign exchange data, that markets react quickly and efficiently to news of changes in economic data, U.S. employment figures for example. Both Malkiel (1990) and Paul (1995) suggested that random price changes, like those generated by flipping a coin, produce series that seem to have trends. Malkiel (2005), a long term advocate of the Efficient Market Hypothesis, contrasted professionally managed investment funds with passively managed funds, stating that were the EMH inaccurate, professionally managed funds should outperform those which were not actively managed. He found no evidence to support this, finding instead that markets seemed to reflect all available information. For the purpose of this investigation I will primarily focus on weak-form EMH given its relationship with technical analysis. As such the following chapter offers a discussion of technical analysis.
3 Technical Analysis
Before we truly begin to consider the Efficient Market Hypothesis in relation to technical analysis, let us first gain an understanding of what technical analysis is and the extent to which it is used within the markets. The term Technical Analysis refers to a myriad of trading techniques. Technical Analysts attempt to forecast prices by the study of past prices and a few other related summary statistics. They believe that shifts in supply and demand can be detected in charts of market action [Brock et al. 1992]. Technical trading is a short-term trading technique, with positions lasting for only a few hours or days. Its use is widespread both individually and in conjunction with fundamental3 analysis. Taylor and Allen (1992) surveyed 213 traders in the London Foreign Exchange Markets to find that nearly 36% of respondents reported using chartist computer graphics packages while some 65% reported using online commercial computer services. The results also indicated the widespread use of technical indicators such as moving averages and other trend-following indicators. The authors also noted that charting was the main forecasting tool of intra-day traders. Cheung and Wong (2001) conducted a further survey of the US markets in which 30% of traders questioned said they would best describe themselves as a technical trader. As Walter Deemer4 points out,
A method of security valuation which involves examining the company's financials and operations, especially sales, earnings, growth potential, assets, debt, management, products, and competition. Fundamental analysis takes into consideration only those variables that are directly related to the company itself, rather than the overall state of the market or technical analysis data. 4 A respected technician who now publishes a daily technical market strategy comments in Florida.
day trader types will embrace classic technical trend lines and oscillators in their frenetic financial adventures because 'normal' investment tools are pretty much useless to them.
3.1 Principles of Technical Analysis

So what are the foundations of Technical Analysis? Neely (1997) describes three principles which guide the behaviour of technical analysts. The first is that market action discounts everything. In other words all price movements are a reflection of the trend in the hopes, fears, knowledge, optimism and greed of market participants [Pring, 2002]. As Drew (1968) noted the price level is never what they [stocks] are worth, but what people think they are worth. As such there is no need to forecast the fundamental determinants of an assets value. In fact Murphy (1986) claimed that asset price changes often precede observed changes in fundamentals. The second principle states that the trend is your friend. Technical analysts maintain that asset prices move in trends and typically do not believe that price fluctuations are random and unpredictable. Neely provides an example of why markets may be inclined to trend. First we assume that there is asymmetric information in the foreign exchange market i.e. some agents will have more information than others, particularly those with a large client base who will know more about their own and their customers demand for foreign currency. It is likely that the trading behavior of these participants will reveal some of their private information to uninformed agents. Let us assume that one agent has obtained some information about the fundamental determinants of exchange rates which is likely to push the exchange rate up. They will purchase the foreign currency, raising the exchange rate as they do. Now let us assume that the less informed participants note this rise and infer that this increase will continue moving as it has in the recent past5. The less informed
Another famous of the bandwagon effect, where behaviour is inferred from others is that of a restaurant. If people see a restaurant which is very busy, they will assume it is busy because the food is so good, and as such go to that one, rather than a quieter one, causing the busy restaurant to become overcrowded.
traders will also purchase the foreign currency6 pushing the exchange rates up themselves. This is known as a self-fulfilling prophecy. Individuals believe the currency is going to rise, and acting upon this belief, cause the currency to rise themselves, independent of other factors. As such, the markets are predisposed to trends. Some practitioners even appeal to Newtons law of motion to explain the existence of trend: trends in motion tend to remain in motion unless acted upon by another force. Predictable trends are essential to a technical analyst. They are what allows traders to profit by buying assets when the price is rising, and sell when the price is falling. The third and final principle is that history repeats itself. The assumption is made that the emotional makeup of investors will not change. As such asset traders will tend to react the same way to the same market conditions and therefore, the subsequent price movements are likely to be similar. Technical analysts do not claim their methods are magical; rather that they take advantage of market psychology [Neely, 1997]. The aim therefore is to uncover signals given off in a current market by examining past market signals. Technical Analysis techniques are explicitly extrapolative, in that they infer future price changes from those of the recent past. To distinguish such trends from shorter run fluctuations, technicians employ two main types of analysis: Charting and Mechanical Rules.
3.2 Technical Analysis Techniques: Charting

Charting involves graphing the history of prices over some period determined by the analyst, to predict future patterns in the data based upon past patterns. This technique is much more subjective than its mechanical counterpart. It requires the analyst to use judgement and skill in finding and interpreting patterns.
This is known as the bandwagon effect.
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Charting is essentially the process of establishing patterns within a series of data, by visual inspection. To identify trends it is first necessary to find local maxima (peaks7) and local minima (troughs) in the data. As figure 3.1 shows, series of peaks and troughs allow us to establish downtrends and uptrends respectively. Figure 3.1 Establishing trends and trend reversals.
1.70 1.65 1.60 1.55 1.50 1.45 1.40 1.35 Oct-99
Series of peaks Fails to break the support level and the trend reverses Series of troughs
Dec-99
Feb-00
Apr-00
Jun-00
Aug-00
Oct-00
Dec-00
GBPUSD spot from October 1999 to February 2001
Once a technician has established a trend line, they will trade as necessary, buying the foreign currency in an uptrend, known as going long, and selling the currency in a down trend, or selling short. Detecting the reversal of an established trend is just as important as identifying the trend itself. If a trend reversal is indicated, a trader can profit by reversing his/her position. Peaks and troughs are also used for this purpose. Local peaks are called resistance levels and local troughs are called support levels. A price failing to break a support level during a downtrend is thought to be an early indication that the trend may soon reverse (see figure 3.1).
A peak (trough) is the highest (lowest) value of the exchange rate within a specified period of time
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Technicians have also identified several patterns which they consider useful in identifying future movements in exchange rates. Such patterns include head and shoulders, rounded tops, rounded bottoms, flags, pennants, and wedges. Let us consider for example the head and shoulders pattern shown in figure 3.2. The head and shoulders pattern is considered by practitioners to be one of the most, if not the most, reliable of all chart patternsTechnical analysts claim that this pattern identified when the second of a series of three peaks is higher than the first and the third, presages a trend reversal [Osler and Chang, 1995]. The line between the troughs of the shoulders is known as the neckline (see figure 3.2). When the exchange rate penetrates the neckline of a head and shoulders pattern, the technician confirms a reversal of the previous uptrend and begins to sell the foreign currency. Figure 3.2 Head and Shoulders Formation
1.45 Shoulders 1.40 Shoulders spot breaks the neckline indicating trend reversal Neckline
Head
1.35
1.30
1.25
1.20 Jun-03
Jul-03
Aug-03
Sep-03
Oct-03
Nov-03
Dec-03
Jan-04
USDCHF spot from June 2003 to January 2004
As Osler and Chang (1995) point out, these patterns are highly nonlinear and complex and such trading rules based on these patterns cannot normally be expressed algebraically. As a result research into these methods has been limited, however with the advent of more sophisticated nonparametric statistical techniques, and increased computing power, papers are beginning to emerge on the subject.
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The first paper written exclusively on the topic, by Levy (1971) tested the predictive power of all thirty two possible 5-point chart patterns, including the head and shoulders discussed above, but found no evidence of profitable forecasting ability. Next, Brock et al. (1992) found that breakouts from observed trading ranges are meaningful predictors of short-term returns using the Dow Jones index. Osler and Chang (1995) found that the head and shoulders pattern appeared to have some predictive power for the German mark and the yen, but not for the four other currencies tested. They also make the point that were one to have invested in all currencies, resulting profits would have been both economically and statistically significant. Lo et al. (2000) tested several patterns using kernel regressions to smooth the data and found that several of the indicators provided incremental information. We can see therefore that research into the profitability of charting techniques has to some extent fallen in their favour. However studies in the field are limited in number. There are still difficulties associated with developing algorithms which can accurately pick out the visual patterns, such as the head and shoulders in figure 2.3, which would be recognised by technicians themselves. As such let us now go on to consider the more subjective mechanical trading rules.
3.3 Technical Analysis Techniques: Mechanical Rules

Charting is highly dependant on the interpretation of the technician viewing the data. Such subjectivity can permit emotions such as fear or greed to affect the trading strategy. Mechanical trading rules avoid such prejudice providing a more consistent and disciplined approach to technical trading. They employ simple statistical rules to obtain buy and sell signals. There are a number of different mechanical trading rules, ranging from the very simple to the highly complex. In the main they can be divided into three subcategories; Filter rules, Moving average rules and Oscillators. Filter rules or trading range break rules counsel buying (selling) a currency when it rises (falls) x percent above (below) its previous local minimum (maximum). The size of
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the filter, and the window from which the local minima is selected, are chosen by the technician. Neely (1997) suggested that filters, in his experience, generally ranged from 0.5% to 3%. The second class of trading rule is the moving average class. By plotting a moving average the technician can distinguish long-run trends from shorter run fluctuations. A moving average is the average closing price of the exchange rate over a given number of previous trading days. For example, the ten-day moving average of an exchange rate series is given by equation 4.1 where S t denotes the closing spot8 price on day t.
1 9 S t i 10 i =0
(4.1)
M (10) t =
The number of days the moving average includes, also known as the length of the window, determines whether the moving average reflects long or short-run trends. Any moving average will be smoother that the original exchange rate series, and a short moving average will be smoother than a long moving average. Figure 4.3 depicts a long 50-day MA against a short 1-day MA (spot itself). A typical moving average trading rule gives a buy (sell) signal when a short moving average crosses a longer moving average from below (above), i.e. when the exchange rate is rising (falling) relatively quickly.
The price at which a particular commodity can be bought or sold on a specified date.
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Figure 3.3 Typical moving average rule.

1.13 1.12 1.11 1.10 1.09 1.08 1.07 1.06 1.05 Jan-98
50-day moving average
When spot is greater than the moving average, go long the currency
spot
When spot is falls below than the moving average, sell the currency
Mar-98 May-98 Jul-98 Sep-98
EURUSD spot from January 1998 to September 1998.
The final class of mechanical trading rule is that of oscillators. These are used for establishing short-term overbought9 or oversold conditions. They are thought to be particularly useful in a non-trending market i.e. when the exchange rate is not moving strongly up or down. A simple oscillator index for example would be the difference between two moving averages: a 5-day moving average minus the 20-day moving average. Oscillator rules suggest buying (selling) the foreign currency when the oscillator index takes an extremely low (high) value. It is therefore logical that an oscillator chart would be useful for generating moving average rule signals. The Relative Strength Index (RSI), developed by Wilder (1978) is a popular simple momentum oscillator. The RSI compares the magnitude of a stock's recent gains to the magnitude of its recent losses and turns that information into a number that between 0 and 100. It is suggested that when the oscillator rises above 70, the underlying is overbought and the trader should go short, while when it dips below 30 it is oversold, and the trader should go long.
Technicians will suggest that a security that is overbought is at levels not technically justified and will resultantly be sold off causing the price of the security to decrease. An overbought security is the opposite of one that is "oversold".
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A large body of research has been conducted based upon these mechanical rules. As Olser (2000) points out Filter rules were found to be profitable as early as 1984 (Dooley and Shafer, 1984) and this finding has been confirmed repeatedly (Sweeney 1986; Levich and Thomas 1993). Moving average crossover rules have also been tested frequently on exchange rates with similar levels of success. Levich and Thomas (1993) used a bootstrap simulation technique to provide evidence of the profitability and statistical significance of technical trading rules in the foreign exchange market. Work by Menkhoff and Schlumberger (1995) and Gencay (1998) have also offered support for these conclusions. We can see there is a body of evidence to support the use of both charting techniques and mechanical rules. However, the concept of successfully predicting future movements in foreign exchange by consulting a history of prices directly contravenes the weak-form efficient market hypothesis. We can see therefore why the dispute between economists and technical analysts continues. As such we will now consider firstly whether, using econometric techniques, our data series can indeed be considered to be random walks and will then test the profitability of a number of commonly used mechanical rules.
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4 Evaluating the Random Walk

We have now seen that the existence of perfectly efficient markets and profitable technical analysis techniques are mutually exclusive. As such we will consider the hypothesis that foreign exchange price data follows a random walk using both a DickeyFuller Unit root test and a KPSS test upon a history of foreign exchange data.
4.1 - The Data

The data consists of 3,95810 observations (from October 16th 1997 to January 18th 2005) for five currency pairs; the US dollar against the Euro, Yen, Australian dollar, Sterling and Swiss franc. All data is the London closing price collected at 16:00 GMT.
4.2 Stationarity and Random Walks

In order to establish whether our time series do indeed follow a random walk we will perform both a Dickey-Fuller unit root test and a KPSS test. In order to understand the tests it is necessary first to gain an understanding of some terminology. First, the concept of stationarity. Stationarity refers to a time series process where the marginal and joint distributions are invariant across time. Therefore a stochastic process is said to be stationary when its mean, variance and covariance do not change throughout the time series, i.e. the following equations must be true: (4.1) E ( yt ) = , t
10
Many thanks the Lehman Brothers for the provision of this data.
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(4.2) (4.3)
V ( y t ) = 2 , t Cov( y t , yt k ) = k , t , k
We can consider either weak or strict stationarity. Strict stationarity implies that the entire distribution of a process does not change with time. Weak stationarity implies that the first and second moments are constant through time. Stationarity can sometimes be determined visually. For example figure 4.1 shows a stationary series, in comparison with figure 4.2 which is clearly non-stationary. Figure 4.1 A stationary Series
0.8 0.6 0.4 0.2 0 -0.2 -0.4 -0.6 -0.8
Figure 4.2 A non-stationary Series

1.50 1.00 0.50 0.00 -0.50 -1.00 -1.50
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Both the Dickey-Fuller and KPSS test are designed to establish whether a process is trend stationary or difference stationary. A Trend Stationary Process (TSP) is a non stationary time series which can be made stationary by regressing it against time. A Difference Stationary Process (DSP) is one where to obtain a stationary series you must successively difference the data points i.e. yt yt 1 . Note that a difference stationary process is the same as a random walk. Consider the random walk equation (equation 2.8) discussed in chapter 2. We can see that by differencing the series (i.e. subtracting ri ,t from both sides of the equation) we obtain the error term i ,t +1 . I.e. the difference process simply yields the error term. We know from the Efficient Market Hypothesis that the error term has a mean of zero and a variance of 2 (2.8) ri ,t +1 = ri ,t + i ,t +1 ri ,t +1 ri ,t = ri ,t ri ,t + i ,t +1
ri ,t = i ,t +1
and as such is a stationary series.
Therefore if we can establish that the process is difference stationary, we are stating that the process is a random walk. As such we can suggest that the market is in this case weak form efficient11.
4.3 The Dickey-Fuller Unit Root test

The Dickey-Fuller test is performed by running the regression in equation 4.1 the full derivation for which can be found in Appendix A.
(4.5)
yt = + ( 1) yt 1 + t
The final test is performed by completing a z-test on the coefficient of yt 1 . If the coefficient is equal to zero then we can state that we have a difference stationary process,
11
Note that this test is only suitable for weak form efficiency.
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and if it is found to be less than zero, then we can say the process is trend stationary. As such the hypotheses are as follows. H0 : 1 = 0 - the process is difference stationary
H1 : 1 < 0 - the process is trend stationary The critical values are obtained using the Dickey-Fuller distribution. This is necessary because if the process is trend stationary, then OLS is superconsistent. I.e. the trend causes the series to converge to its asymptotic distribution faster than the normal distribution. As such Gaussian critical values are inaccurate, and the Dickey-Fuller distribution, which compensates for superconsistency, is used. While the Dickey-Fuller test is useful, Schwert (1989) provided Monte Carlo evidence to point out size distortion problems in its estimation. In addition DeJong et al. (1992) suggested that although better than its close competitors, the Dickey-Fuller test had a low power against plausible trend-stationary alternatives. As such we will also use a KPSS test.
4.4 The Kwiatkowski, Phillips, Schmidt, and Shin (KPSS) Test

The Kwiatkowski, Phillips, Schmidt, and Shin (KPSS) test differs from the Dickey-Fuller test described previously in that the series is assumed to be (trend) stationary under the null, rather than the null being non-stationary as in Dickey-Fuller. The KPSS statistic is deemed by many academics to be powerful test of stationarity. The test is intended to complement unit root tests such as the Dickey-Fuller [Kwiatkowski et al., 1992]. It is often used in conjunction with Dickey-Fuller in order to compensate for the likelihood of the Dickey-Fuller committing a type I error, i.e. it incorrectly rejecting the possibility of a unit root in favour of trend stationarity. The two tests corroborating each other is deemed to be a good indication of the output being accurate.
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The KPSS statistic uses the residuals from an OLS regression on the exogenous variables: (4.6)
Yt = xt ' + U t
The KPSS statistic is a modified Lagrange Multiplier test, given in equations 4.7, where
S (t ) 2 T 2 f0
(4.7)
LM =
t
f 0 is an estimator of the residual spectrum at frequency zero (in this example we use a
Bartlett kernel12 to estimate f 0 ) and S (t ) is a cumulative residual function as in equation 4.8.

t
(4.8)
S t = U r
r =1
The residuals are given by

U t = y t x t ' ( 0) .
(4.9)
The hypotheses are as follows. H0 : the process is trend stationary H1 : the process is difference stationary
12
Kernal based estimators of the zero-frequency spectrum is based on a weighted sum of the autocovariances. The Bartlett Kernal is a type of kernel function whereby;
K ( x) =
1 x 0
If x 1 otherwise
21
The reported critical values for the LM test statistic are based upon the asymptotic results presented in Kwiatkowski et al. (1992) (Table 1, p. 166).
4.5 Results and Analysis

Table 4.1 below details test statistics, p-values and critical values for each currency pair obtained by performing a Dickey-Fuller unit root test on the data. The full results can be found in Appendix B. Table 4. 1 Results from unit root analysis. Currency Pair EURUSD USDJPY GBPUSD USDCAD USDCHF Test stat -0.94256 -2.0938 -1.04026 -1.40581 -1.43738 p-value 0.9496 0.5484 0.9367 0.8593 0.8499 Critical values 5% -3.41 -3.41 -3.41 -3.41 -3.41 10% -3.12 -3.12 -3.12 -3.12 -3.12
We can see that t-statistics range from -0.943 to -2.094 across the currencies. The critical values from the Dickey-Fuller distribution are -3.41 and -3.12 at the 5% and 10% levels respectively. As such we retain the null hypothesis that 1 = 0 in every case. I.e. the data seems to be a difference stationary process or random walk. As such the analysis here finds in favour of the Efficient Market Hypothesis. It is also worth noting that the p-values, i.e. the lowest percentage at which one could reject the null hypothesis, are all very high - the lowest being 54.84% for the yen series. As such, the evidence is strongly in favour of the given forex data following a random walk. Given the low power of Dickey-Fuller tests we have also employed a KPSS test, the results for which are given in table 4.2.
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Table 4. 2 Results from KPSS testing. Currency Pair EURUSD USDJPY GBPUSD USDCAD USDCHF Test stat 1.62322 1.55730 1.04937 1.81808 2.12124 Critical values 5% 0.463 0.463 0.463 0.463 0.463 1% 0.739 0.739 0.739 0.739 0.739
We can see the test statistics range from 1.049 to 2.121 across the currencies. The critical values at the 5% and 1% are 0.463 and 0.739 respectively. As such in every case we reject the null hypothesis of stationarity in favour of a unit root. The KPSS outputs therefore back up the results obtained from the Dickey-Fuller test. As such we reconfirm the result that the series tested follows a random walk and we again find in favour of the efficient market hypothesis.
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5 - Evaluating Technical Analysis
We have seen strong evidence to suggest that the data series used do follow a random walk. However, as mentioned in sections 3.2 and 3.3 there have been several studies indicating these rules are profitable. As such I will now examine the profitability of several technical analysis techniques.
5.1 The Tests

As I have mentioned previously one of a major problems with evaluating technical trading strategies is that many of the rules are subjective, requiring a level of judgement and skill to employ. To conduct a fair test we require fixed objective and commonly used trading rules which do not require individual skill or judgement to determine buy and sell decisions. As such I have chosen to test Moving Average rules, Filter rules and an RSI (Relative Strength Index). Moving Average rules provide a buy signal when the short moving average rises above the long moving average, otherwise offering a sell signal. In this article I have selected long moving averages of 10 and 50 days and short moving averages of 1 and 5, as recommended by Neely (1997), for which I will test all combinations. Filter rules offer a buy signal when the exchange rate rises x percent over a previous recent minimum. In this study I will consider a window of 5 days for the previous minima, and 6 filters ranging from 0.5% to 3%, to provide a reasonable range.
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The Relative Strength Index (RSI) is a momentum oscillator which compares the size of recent gains in a security against the size of recent losses. These are then transformed to obtain a value between 100 and 0. Appendix C details the construction of the RSI. In this study we obtain a sell signal when the index rises above 70 and a buy signal when it dips below 30. We consider windows of 5, 10, 14 and 30 days. Now to consider the way in which I will calculate the profits from my analysis. In foreign currency markets a long position involves the purchase of foreign currency, i.e. a bet that the currencys value will rise. A short position is a bet the currency will fall in value. As such I have calculated the return to a long position as follows; R f i tf + S t i td t
(5.1)
The return on investing in a foreign currency ( R f ) is approximately equal to the foreign t overnight interest rate ( itf ) plus the change in the spot rate ( S t ) minus the domestic interest rate ( itd ), assuming the exchange rate is defined as the number of domestic units available for one unit of foreign currency. The return on the short position will simply be the negative of this value. In this study the domestic unit is assumed to be dollars. I have not as of yet included transaction costs.
5.2 Results and Analysis

I will now consider the returns from each strategy in turn to evaluate their profitability. Moving Average Table 5.1 provides a breakdown of the returns to each currency from the moving average trading strategy, offering annualised average return, annual standard deviation of returns and a Sharpe ratio. I have also included a portfolio13 return for each trading strategy.
13
A portfolio of all the currencies tested
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Table 5.1 Returns from a range of Moving Average trading strategies.

Moving Average Short MA EURUSD
1 1 5 5 1 1 5 5 1 1 5 5 1 1 5 5 1 1 5 5 1 1 5 5 Total
Long MA
10 50 10 50 10 50 10 50 10 50 10 50 10 50 10 50 10 50 10 50 10 50 10 50
Annualised average return

0.65% 2.91% 2.70% 4.33% -1.50% -1.77% -2.62% -1.21% -2.48% -1.24% 3.43% -0.43% 1.48% 0.66% 0.27% -0.04% -1.08% 0.78% 1.57% 4.30% -0.59% 0.27% 1.07% 1.39% 0.53%
Standard Deviation
10.15% 10.15% 10.15% 10.15% 11.72% 11.72% 11.72% 11.72% 7.92% 7.92% 7.92% 7.92% 6.73% 6.73% 6.73% 6.73% 10.89% 10.89% 10.89% 10.88% 5.11% 5.27% 5.11% 5.32% 4.08%
Sharpe Ratio
0.064 0.287 0.266 0.426 -0.128 -0.151 -0.223 -0.103 -0.313 -0.156 0.434 -0.055 0.220 0.098 0.040 -0.005 -0.100 0.071 0.144 0.395 0.000 0.000 0.001 0.001 0.001
USDJPY
GBPUSD
USDCAD
USDCHF
Portfolio
We can see that overall 60% of the trading strategies yielded a positive return, the maximum return being 4.33%, and the minimum being -2.62% over the period. The average return was 0.53%. EURUSD offered the most favourable returns with profits made with every combination of moving averages, while USDJPY showed losses for every combination. In terms of portfolio returns, only the strategy employing a 1-day short MA and a 10-day long MA showed a loss. Perhaps the periods were simply too short to effectively distinguish short run fluctuations from long run trends. The most successful strategy was that which used a 5-day short MA and a 50-day long MA giving annualised profits of 1.39%.
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The Sharpe ratio, which is calculated by dividing annual returns by the annual standard deviation (a measure of risk) offers a simple way of measuring the return to risk. The Sharpe ratios range from -0.313 to 0.434, averaging at 0.048. This is relatively low; only 24% of the Sharpe ratios are higher than the 0.15 obtained by a buy-and-hold strategy in the S&P 500 over the same period. This therefore indicates that the average return rules are not as satisfactory as previously thought, though there are indications that some may have some merit. Filter Rules Table 5.2 offers a breakdown of the returns to the filter strategy again providing the annualised average return and standard deviation and the Sharpe ratio for each technique. We can see for the filter rules that our returns are quite poor, the maximum return on a trading rule being 1.86% and the minimum -2.88%. Overall the average return was a loss of 0.14%. Only 30% of the filter rule trades offer a positive return, although 8 of those do offer a Sharpe ratio greater than the 0.15 obtained from the buy-and-hold strategy for the S&P. Only the 2.5% and 3% filters offer a positive portfolio return, indicating the ability of filter rules to predict future exchange rate movements is indeed limited. One could in fact suggest that rather than a 0.5% increase in the exchange rate being an indication that the currency will rise further, it could be an indication that the currency is overbought, and as such should be sold. This would yield the opposite of the returns detailed in table 5.2 providing an annualised profit of 0.42% which would indeed be more favourable than those currently given.
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Table 5.2 Returns to filter rule trading strategies.

Filter Rules Annualised avg return
-1.06% -0.03% -0.30% -0.30% -0.69% -0.30% -2.15% -1.51% -0.70% 0.42% 1.86% 1.60% 1.61% 0.64% -0.16% -0.30% 0.25% -0.05% 1.74% 1.08% -0.11% -0.43% -0.15% 0.05% -2.88% -2.23% -2.15% -1.67% -0.31% -0.52% -0.42% -0.54% -0.26% -0.02% 0.22% 0.17% -0.14%
Filter EURUSD
0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% Total
St Dev
7.02% 5.40% 3.95% 2.92% 1.51% 0.96% 9.10% 7.69% 6.61% 5.76% 4.73% 4.42% 5.07% 3.62% 2.38% 1.61% 0.96% 0.50% 4.40% 2.67% 1.78% 1.25% 0.37% 0.13% 7.71% 6.09% 4.64% 3.39% 2.26% 1.10% 3.40% 3.02% 2.78% 1.41% 1.06% 1.15% 1.66%
Sharpe Ratio
-0.152 -0.006 -0.077 -0.102 -0.458 -0.318 -0.236 -0.197 -0.105 0.073 0.394 0.362 0.317 0.178 -0.069 -0.183 0.262 -0.105 0.395 0.405 -0.063 -0.341 -0.419 0.370 -0.373 -0.366 -0.465 -0.492 -0.136 -0.473 0.000 -0.001 0.000 0.000 0.001 0.001 0.000
USDJPY
GBPUSD
USDCAD
USDCHF
Portfolio
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Relative Strength Index The breakdown of results from the Relative Strength Index is given in table 5.3. We again show annualised average returns, standard deviations and Sharpe Ratios. Table 5.3 Breakdown of returns from the RSI trading strategy.
Relative Strength Index Time Period Annualised (days) avg return St Dev EURUSD
5 10 14 30 5 10 14 30 5 10 14 30 5 10 14 30 5 10 14 30 5 10 14 30 Total -0.46% 0.35% 0.04% -0.26% -1.33% 1.54% 0.74% -0.34% 0.01% 0.03% 0.72% 0.97% -1.00% -0.96% -0.52% 0.64% -1.30% -0.73% -0.64% -0.15% -0.82% 0.05% 0.07% 0.17% -0.13% 5.80% 4.07% 3.53% 2.28% 7.41% 4.91% 4.18% 3.07% 4.85% 3.41% 2.61% 2.12% 4.08% 2.78% 2.26% 1.85% 6.29% 4.37% 3.44% 2.47% 2.95% 2.02% 1.71% 1.24% 1.68%
Sharpe Ratio
-0.079 0.087 0.010 -0.114 -0.179 0.315 0.176 -0.112 0.001 0.010 0.276 0.459 -0.244 -0.346 -0.230 0.346 -0.207 -0.166 -0.187 -0.061 -0.001 0.000 0.000 0.001 0.000
USDJPY
GBPUSD
USDCAD
USDCHF
Portfolio
We can see for the RSI trading rule that the annualised returns range from -1.33% to 1.54%, averaging at -0.13%. In this case 45% of the rules yield positive returns, with the 30 day RSI providing the best results overall with a portfolio return of 0.17%. In terms of the Sharpe ratio, only 5 of the 20 scenarios tested yielded offered a risk adjusted return higher than the S&P 500 over the same trading period, the maximum being 0.459 for the
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30 day indicator applied to the GBPUSD time series. The results for this trading strategy seem to fall in favour of the Efficient Market Hypothesis rather than Technical Analysis. Overall we can see that the returns from the moving average rules offer most support for technical analysts. Both the filter and RSI trading strategies on average yield negative returns. The results as detailed above assume no transaction costs. By including transaction cost of 5 basis points for each round trip (i.e. buying and then selling the currency) the average return for the moving average rules falls from 0.53% to -0.07%. However given the low frequency of trade signal changes, the most successful strategy, employing a 5-day short MA and a 50-day long MA retains an annual return of 1.17% when transaction costs are included. This is however the exception to the rule. But what does this mean for the efficient market hypothesis? The data certainly agrees with Malkiels (1990) suggestion that technical analysis cannot consistently outperform a strategy of simply buying and holding a diversified group of securities. The work on the relative strength index reconfirms the ideas from Lesmond et al. (2001) which found that relative strength rules are rarely profitable, particularly after the inclusion of transaction costs. Overall the research offers strong support for at the very least, weak form EMH.
5.3 Limitations of the analysis

There are problems associated with inferring the degree of market efficiency using the level of profitability from these trading rules. The first is the data. To test the profitability of a trading rule accurately the researcher requires actual prices and interest rates from a series of market transactions. However, such simultaneous quotes for daily exchange rates and interest rates are not generally available. Although the differences should be minimal, some could argue that the trades suggested could not have taken place. The second problem involves the measurement of risk. Risk is notoriously difficult to measure. For example the Equity Premium Puzzle, which notes that there is no
30
commonly accepted model of risk which can explain why the return on stocks have been so much higher than the return on bonds remains a source of contention for economists. Proponents of EMH maintain that the discovery of an apparently successful trading rule may not indicate market inefficiency, but rather that risk is not properly measured. In this study we employ the Sharpe ratio, a widely used measure of risk, which is calculated by dividing annual returns by the annual standard deviation. A higher Sharpe ratio indicates either higher average excess returns, or lower volatility of returns. A commonly used benchmark of a good Sharpe ratio is that of the S&P 500, which in this study I have estimated over the given period to be 0.15. However the Sharpe ratio ignores an important concept in finance in that it does not account for the fact that an investment is risky only to the extent that its return is correlated with the return to a broad measure of the investments available [Neely, 1997]. In short, Sharpe ratios do not account for the fact that some risk can be diversified and as such, may overestimate risk. The final argument is the nature of the tests. As I have previously mentioned, to conduct a fair test we require fixed, objective and commonly used trading rules which do not require individual skill or judgement to determine buy and sell decisions. However it could be said that technical analysis is profitable when conducted by a skilled technician. This testing technique does not allow for the skill of the technician and could be said to underestimate the returns available.
5.4 This Analysis and Other Research

In contrast with the research described in section 4.2 the technical analysis techniques tested in section 5.2 were largely unprofitable. Dooley and Shafer (1984), Sweeney (1986), Levich and Thomas (1993) and Neely (1997) have all offered evidence to suggest that the rules tested were profitable, so why might there be a discrepancy between their results and my own? The first factor to consider is the length of my data set, which ranges from 1997 to 2005. Many of the above studies use data sets lasting over 20 years. There is no doubt that the
31
markets will have changed over this time. For example SETS (Stock Exchange Electronic Trading Service), the first London Stock Exchange electronic trading platform, was only launched in 1997. Such technological advances will undoubtedly improve information dissemination and as such improve market efficiency. Yanxiang Gu (2004) found strong evidence, using NASDAQ data, that efficiency had markedly improved in the equity market over the period 1971 to 2001. There is nothing to suggest the foreign exchange market should not have seen the same improvements. It has also been noted that many predictable patterns seem to disappear after they are published in the finance literature [Malkiel, 2003]. Schwert (2001) suggested that practitioners learn quickly about any true predictable pattern and exploit it to the extent that it becomes no longer profitable. If this is true then publishing research in this arena is something of a double edged sword. As research gains renown and the use of the techniques it promotes increases, the profitability of the techniques will diminish. Perhaps a logical extension to this project would be a study considering the profitability of these rules over time. Schwert (2001) also noted the problem of data mining. He remarked that researchers sift through large quantities of financial data and that their normal tendency is to focus on results that challenge perceived wisdom. He also observed that some rules, purely by chance, produce excess returns and it is these studies which will be published. As such it is possible that the results from the studies mentioned simply constitute a lucky accident, rather than truly challenging the Efficient Market Hypothesis. One solution to data-mining was proposed by Neely, Weller and Dittmar (1997) who recommended applying genetic programming techniques. They suggested that by using a computer to search for successful trading rules, and then testing them on out-of-sample data, one could ascertain whether the returns were merely a lucky accident, or genuinely profitable.
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6 Further Considerations
My intention with the following section is simply to highlight some other issues surrounding the debate on Technical Analysis by considering 3 topics; Central Bank intervention, Behavioural Finance and the Paradox of Efficient Markets.
6.1 Central Bank Intervention

One popular explanation for the profitability of some technical trading rules is that technical traders are able to consistently profit from central bank intervention. Some central banks (CBs) frequently intervene in the foreign exchange market in order to influence other economic variables such as employment and inflation. In 2003 for example, the Japanese government bought on average 22 billon dollars a month in an effort to stem the appreciation of the yen and improve the Japanese export market. Because the CBs aim is not money making, but rather control of macroeconomic variables, they may be willing to accept losses. As such, some have interpreted trading rule profits as a transfer from central banks to technical traders. Dooley and Shafer (1983) stated that at worst central bank intervention would introduce noticeable trends into the evolution of exchange rates and create opportunities for alert market participants to profit against the central bank. Some research has found in favour of this hypothesis. Lebaron (1996) found that by removing days where the Federal Reserve14 was actively intervening returns on previously profitably technical trading rules were significantly reduced. Neely and Weller
14
The US Central Bank
33
(1997) found that intelligent trading rules tended to trade against the Fed, in that they suggested to buy dollars when the Fed was selling them. However, Leahy (1995) found that Federal Reserve on average profited from its foreign exchange interventions rather than accepting losses as in the argument above. As such some debate continues in this arena.
6.2 The Representativeness heuristic

Secondly I would like to discuss the representativeness heuristic. The representative heuristic was first identified by psychologists Amos Tversky and Daniel Kahneman. Under the representativeness heuristic, we judge things as being similar based on how closely they resemble each other using prima facie, often superficial qualities, rather than essential characteristics. Why is this relevant to technical analysis? According to Tversky and Kahneman (1974), an important manifestation of the representativeness heuristic is that people think they see patterns in what are actually random sequences. As such, even if financial data follows a random walk, it is only natural for people to see patterns in the data. Malkiel in his book A Random Walk Down Wall Street describes an experiment he performed with his students. They were asked to construct a stock chart showing the movements of a hypothetical stock, initially selling at $50 per share. The movement in one day was determined by the flip of a coin, a head meant the stock closed a point higher than the preceding close, tails meant a point lower. Figure 7.1 below shows an example I have created using a similar15 process.
15
Rather than employing a coin I used a random number generator which generated numbers in a range of 0 to 1. The hypothetical stocks value was increased when the number generated was greater than 0.5, and decreased when it was lower than 0.5.
34
Figure 6.1 Hypothetical stock-chart created using a random process

60 58 56 54 52 50 48 46 44
We can see the chart looks remarkably like a foreign exchange series. It is easy to pick out patterns, trends and cycles in the data because we are naturally inclined to do so. In conclusion the Representativeness heuristic supports the efficient market hypothesis while offering comfort to technical analysts. It simply means that if individuals are naturally inclined to see patterns in the data, it is easy to see why technical analysis, in particular charting, is so popular.
6.3 The Paradox of Efficient Markets
Finally I would like to consider the paradox of efficient markets. Grossman and Stiglitz (1980) identified a major theoretical problem with the Efficient Market Hypothesis which has been coined the paradox of efficient markets. The argument is as follows: we first note that foreign exchange market returns are determined by fundamentals such as inflation and interest rates etc., and then that despite information on these variables being costly to acquire and examine, traders do so on a regular basis. It seems logical that traders therefore must be able to obtain some excess returns by trading on their analysis, or it would be unprofitable to perform the analysis in the first place. However, if markets are perfectly efficient, traders would not be able to make excess returns on any available
35
information. As such markets cannot be perfectly efficient in the sense that exchange rates are always where the fundamentals say they should be. One simple resolution to this paradox would be to say that by performing such analysis, traders can recoup some of the costs by having marginally better information on where the exchange rate should be than other players in the market. Individuals who are less informed suffer an exchange rate which is close enough to its fundamental value to prevent them from profiting from the difference. In the light of this Campbell Lo and MacKinlay (1997) suggested that rather than establishing whether the markets are efficient or not, we should instead concentrate upon evaluating the degree of inefficiency in the market. This is not to state that technical analysis must work, but more that markets cannot be perfectly efficient.
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7 - Extensions
There are several obvious extensions to this project including: an increase in the number of currencies covered; a greater number of trading strategies tested for example, using several different windows for the filter rules. Perhaps out of sample testing as suggested by Neely Weller and Dittmar (1997) would also be advantageous. It would also be interesting to repeat this study using a larger sample of data, to discover whether there has been any evolution in the returns from technical analysis over time. This may offer insight into the theory that technological advances, while aiding technical analysts in their work, have also hindered their potential profits by increasing market efficiency. Also an examination of whether using filter rules to signal overbought and oversold conditions would be profitable, given their poor performance in this paper, would also be an interesting extension.
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8 - Conclusions
Overall we have seen that technical analysis is a wisely used trading strategy in the foreign exchange market. Many different techniques have been developed and are now employed daily across the globe. However, we have also noted a divergence in thought between economists and technicians in that excess returns from using technical analysis techniques are incompatible with the efficient market hypothesis. Initially we found evidence, using a Dickey-Fuller unit root test, that foreign exchange data follows a random walk. We confirmed this result using a KPSS statistic, thereby offering convincing support for the hypothesis that the data tested was a difference stationary process. As such our initial investigations found in favour of the Efficient Market Hypothesis. We have seen that several recent research projects have shown simple technical analysis techniques to be profitable. However despite finding that the moving average technique using a 50-day long MA and 10-day short-MA was profitable, even after the inclusion of transaction costs, in general our own research did not show such positive results. This could be attributed to a small data sample and a tendency for researchers to data mine. We have also suggested that over time markets have increased in efficiency as a result of technological advancements and as such our sample focused too heavily on recent data to effectively capture past inefficiencies in the markets. There is also evidence to suggest that as researchers find profitable patterns, practitioners employing the techniques quickly exploit them to the extent they are no longer profitable.
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Overall the weight of evidence seems to fall in favour of the efficient market hypothesis. We have seen that there is natural inclination for individuals to see patterns in random series of data and as such, that it is perhaps inevitable that investors will tend to employ technical analysis, whether explicitly or otherwise. However, we have also seen that the markets may not necessarily be perfectly efficient. The paradox of efficient markets has shown us that in order to collect and analyse costly market data to the extent that investors do, they must receive some reward in the form of increased profits or it would not be profitable to perform the analysis at all. As such the markets cannot be perfectly efficient. Overall however, this study offers convincing evidence that whatever market inefficiencies exist are diminutive in size and impact and that the efficient market hypothesis seems to be an accurate representation of the foreign exchange market.
7287 words
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http://www.lse.co.uk/financeglossary.asp?searchTerm=&iArticleID=1902&definition=fo reign_exchange_reserves (Accessed March 2005) The Relative Strength Index (RSI), http://www.stockcharts.com/education/IndicatorAnalysis/indic_RSI.html (Accessed March 2005)
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Bibliography
Dickey, D.A. and W.A. Fuller, 1979. The Distribution of the estimators for autoregressive time series with a unit root, Journal of American Statistical Association, Issue 74: 427-431 Dixon, C. and Sanciaume A. A Sunny Spell for the Dismal Science, Lehman Brothers Global Foreign Exchange and Local Markets Weekly, 22 April 2004. Howells, G. and K. Bain, The Economics of Money and Banking A European Text, Second Edition, Prentice Hall, Essex, 2002. Faulkner, J.R. BoJ Intervention Risk and Return, Lehman Brothers Global Foreign Exchange and Local Markets Weekly, 1 October 2003. Maddala, G.S., Introduction to Econometrics, Third Edition, Wiley, West Sussex, 2001. Osler, Carol L., 2003. Currency Orders and Exchange Rate Dynamics: An Explanation for the Predictive Success of Technical Analysis. Journal of Finance, Volume 58, Issue 5 (October): 1791-1820 Wilder, J. Welles, 1978. New Concepts in Technical Trading Systems. Greensboro, NC: Trend Research. Wooldridge, J.M., Introductory Econometrics: A modern Approach, Second Edition, Thomson South Western, Ohio, 2003. 46
Appendix A Construction of the Dickey- Fuller test

There are two possible techniques for making a non-stationary time series, stationary: 1) Estimating the Regressions on time 2) Successive differencing The suitability of the method used will depend upon the nature of the series. For example if we consider that the series yt is generated via the following mechanism;
(A4)
yt = + t + ut
Where;
+ t - form the trend. A constant plus a coefficient of time.

ut - Stationary series with a mean zero and variance 2
This is known as a trend stationary process (TSP). If you de-trend this series by estimating the regression on time then this leaves you with the series stationary series u t . However if you difference this series you would obtain yt = + u t u t 1 . This given that has not given us the stationary series u t we required. This is known as an I(0) process. Let us now to consider a process generated by a different mechanism;
(A5)
yt yt 1 = + t
47
Where t is a stationary series with zero mean and 2 . This is otherwise known as a Difference Stationary Process (DSP) or a random walk. When you take a first difference of yt it becomes stationary with mean . This is known as an I(1) process given that it will need to be first differenced to become stationary. To differentiate between these two series, and to establish which method to use we employ a test known as the Dickey-Fuller test. If we consider the model;
(A6)
yt = + yt 1 + t + ut
We know from our previous analysis that if this belongs to the DSP model
the
coefficient of y t 1 in the DSP model below (rearranged from (A5)) will equal 1 and
will equal 0 given that a DSP process has no time trend.

(A7)
yt = + yt 1 + t
However if the model falls into the TSP class then <1 such that we obtain equation (A4).
(A4)
yt = + t + ut
We therefore employ the Dickey-Fuller unit root test which establishes the nature of the model by establishing whether = 1 and is therefore a DSP, or whether is less than 1 and therefore is a TSP. The usual form of the Dickey-Fuller test is as follow;
(A8)
yt = + t + ( 1) yt 1 + t
We can construct the Dickey-Fuller using the following methodology. If we split equation (A7) into 2 constituent parts such that
48
y t = + t + z t becomes
(A9) where
yt = 0 + 1t + z t
z t = yt 1 + u t (A10) z t = z t 1 + t we can re-arrange (1) in terms of z t and then lag the whole equation by one period to obtain; (A11) z t 1 = yt 1 0 1t 1 therefore substituting (A11) into (A10) we get (A12) z t = ( y t 1 0 1t 1) + t (A14) into (A9) (A15) yt = 0 + 1t + ( yt 1 0 1t 1) + t yt = 0 + 1t + yt 1 0 1t + 1 + t yt = 0 0 + 1 1t + 1t + yt 1 + t (A17) yt = (1 ) 0 + 1 + 1 (1 )t + yt 1 + t where (A18) (1 ) 0 + 1 = (A19) 1 (1 ) =
49
therefore (A17) becomes (A20) yt = + t + yt 1 + t subtract y t 1 to obtain yt yt 1 = + t + yt 1 yt 1 + t (A21) yt = + t + ( 1) yt 1 + t Therefore the hypotheses are as follows; H0: -1=0 H1: -1<0 Therefore if =1 the coefficient of
yt 1 will not be statistically different from 0.
We should be aware that there are three forms of the Dickey-Fuller test however; there are those which do not include an intercept, those which include an intercept but not a time trend and those which include both an intercept and a time trend. Their forms are given below; No intercept
(A22)
yt = ( 1) yt 1
Intercept but no time trend.
(A21)
yt = + ( 1) yt 1 + t
50
Intercept and time trend
(A22)
yt = + t + ( 1) yt 1 + t
You can determine whether to include the values based on a visual inspection of the data. If series seems to have an obvious time trend (i.e. it seems to be a random walk with a drift term) then you will need to include both an intercept and a trend. Figure 1.1 (showing EURUSD spot rates) provides a good indication of what a series for which you would include both a time trend and an intercept would look like.
51
Appendix B Dickey-Fuller Outputs
Table B1 E-views output EURUSD Dickey-Fuller Unit root test. Null Hypothesis: EURUSD has a unit root Exogenous: Constant, Linear Trend Lag Length: 0 (Automatic based on SIC, MAXLAG=25) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. Augmented Dickey-Fuller Test Equation Dependent Variable: D(EURUSD) Method: Least Squares Date: 03/26/05 Time: 22:36 Sample (adjusted): 10/17/1997 1/11/2005 Included observations: 1888 after adjustments Variable Coefficient EURUSD(-1) -0.001193 C 0.000757 @TREND(10/16/1997) 6.27E-07 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 0.002449 0.001390 0.006699 0.084603 6773.371 2.101309 -0.942559 -3.962910 -3.412190 -3.128019 Prob.* 0.9496
Std. Error 0.001266 0.001287 2.95E-07
t-Statistic -0.942559 0.588078 2.122258
Prob. 0.3460 0.5566 0.0339 9.60E-05 0.006704 -7.172003 -7.163195 2.313456 0.099200
Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)
52
Table B2 E-views output GBPUSD Dickey-Fuller Unit root test. Null Hypothesis: GBPUSD has a unit root Exogenous: Constant, Linear Trend Lag Length: 0 (Automatic based on SIC, MAXLAG=25) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. Augmented Dickey-Fuller Test Equation Dependent Variable: D(GBPUSD) Method: Least Squares Date: 03/26/05 Time: 22:37 Sample (adjusted): 10/17/1997 1/11/2005 Included observations: 1888 after adjustments Variable Coefficient GBPUSD(-1) -0.001576 C 0.002118 @TREND(10/16/1997) 5.73E-07 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 0.001557 0.000498 0.008125 0.124437 6409.147 1.968945 -1.040262 -3.962910 -3.412190 -3.128019 Prob.* 0.9367
Std. Error 0.001515 0.002364 3.58E-07
t-Statistic -1.040262 0.895856 1.601093
Prob. 0.2984 0.3704 0.1095 0.000131 0.008127 -6.786172 -6.777364 1.470078 0.230171
53
Table B3 E-views output USDCAD Dickey-Fuller Unit root test. Null Hypothesis: USDCAD has a unit root Exogenous: Constant, Linear Trend Lag Length: 0 (Automatic based on SIC, MAXLAG=25) Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. Augmented Dickey-Fuller Test Equation Dependent Variable: D(USDCAD) Method: Least Squares Date: 03/26/05 Time: 22:37 Sample (adjusted): 10/17/1997 1/11/2005 Included observations: 1888 after adjustments Variable Coefficient USDCAD(-1) -0.002258 C 0.003893 @TREND(10/16/1997) -7.11E-07 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 0.003381 0.002323 0.006035 0.068661 6970.463 2.092301 t-Statistic -1.405812 -3.962910 -3.412190 -3.128019 Prob.* 0.8593
Std. Error 0.001606 0.002486 2.84E-07
t-Statistic -1.405812 1.565804 -2.505981
Prob. 0.1599 0.1176 0.0123 -8.63E-05 0.006042 -7.380787 -7.371979 3.196967 0.041108
54
Table B4 E-views output USDCHF Dickey-Fuller Unit root test. Null Hypothesis: USDCHF has a unit root Exogenous: Constant, Linear Trend Lag Length: 0 (Automatic based on SIC, MAXLAG=25) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. Augmented Dickey-Fuller Test Equation Dependent Variable: D(USDCHF) Method: Least Squares Date: 03/26/05 Time: 22:37 Sample (adjusted): 10/17/1997 1/11/2005 Included observations: 1888 after adjustments Variable Coefficient USDCHF(-1) -0.002270 C 0.004074 @TREND(10/16/1997) -8.78E-07 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 0.002045 0.000986 0.010201 0.196147 5979.568 2.113917 -1.437383 -3.962910 -3.412190 -3.128019 Prob.* 0.8499
Std. Error 0.001579 0.002597 4.79E-07
t-Statistic -1.437383 1.568516 -1.833415
Prob. 0.1508 0.1169 0.0669 -0.000143 0.010206 -6.331110 -6.322302 1.931680 0.145191
55
Table B5 E-views output USDJPY Dickey-Fuller Unit root test. Null Hypothesis: USDJPY has a unit root Exogenous: Constant, Linear Trend Lag Length: 0 (Automatic based on SIC, MAXLAG=25) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. Augmented Dickey-Fuller Test Equation Dependent Variable: D(USDJPY) Method: Least Squares Date: 03/26/05 Time: 22:38 Sample (adjusted): 10/17/1997 1/11/2005 Included observations: 1888 after adjustments Variable Coefficient USDJPY(-1) -0.004821 C 0.611879 @TREND(10/16/1997) -5.67E-05 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 0.002513 0.001455 0.887624 1485.145 -2452.391 1.959558 -2.093804 -3.962910 -3.412190 -3.128019 Prob.* 0.5484
Std. Error 0.002302 0.289341 4.09E-05
t-Statistic -2.093804 2.114729 -1.387103
Prob. 0.0364 0.0346 0.1656 -0.009256 0.888270 2.601050 2.609858 2.374478 0.093341
56
Appendix C Calculating the RSI

Having selected your window, n, it is necessary to calculated the daily gains and losses from the exchange series. From this you can calculate the average gain and the average loss over the past week. Average Gain = Average Loss = (Total Gains / n) (Total Losses / n)
This first relative strength calculation is obtained by dividing the average again by the average loss. First RS = (Average Gain / Average Loss)
From this the smoothed relative strength value is obtained as follows. [(previous Average Gain) x (n-1) + Current Gain] / n [(previous Average Loss) x (n-1) + Current Loss] / n
Smoothed RS =
This value is indexed as below to provide the final Relative Strength Index (RSI)
100 1 RS
RSI
= 100
57

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Can Technical Analysis Disprove the Efficient Market Hypothesis? A Foreign Exchange Example.

2 - The Efficient Market Hypothesis

) is deemed a white noise.

where i and j represent different securities.

Substituting into equation (2.1) we obtain (2.8) ri ,t +1 = ri ,t + i ,t +1

3.1 Principles of Technical Analysis

3.2 Technical Analysis Techniques: Charting

This is known as the bandwagon effect.

GBPUSD spot from October 1999 to February 2001

USDCHF spot from June 2003 to January 2004

3.3 Technical Analysis Techniques: Mechanical Rules

Figure 3.3 Typical moving average rule.

50-day moving average

EURUSD spot from January 1998 to September 1998.

4 Evaluating the Random Walk

4.1 - The Data

4.2 Stationarity and Random Walks

Figure 4.2 A non-stationary Series

and as such is a stationary series.

4.3 The Dickey-Fuller Unit Root test

4.4 The Kwiatkowski, Phillips, Schmidt, and Shin (KPSS) Test

Bartlett kernel12 to estimate f 0 ) and S (t ) is a cumulative residual function as in equation 4.8.

The residuals are given by

4.5 Results and Analysis

5 - Evaluating Technical Analysis

5.1 The Tests

5.2 Results and Analysis

A portfolio of all the currencies tested

Table 5.1 Returns from a range of Moving Average trading strategies.

Annualised average return

Table 5.2 Returns to filter rule trading strategies.

5.3 Limitations of the analysis

5.4 This Analysis and Other Research

6.1 Central Bank Intervention

The US Central Bank

6.2 The Representativeness heuristic

Figure 6.1 Hypothetical stock-chart created using a random process

6.3 The Paradox of Efficient Markets

Appendix A Construction of the Dickey- Fuller test

+ t - form the trend. A constant plus a coefficient of time.

will equal 0 given that a DSP process has no time trend.

yt 1 will not be statistically different from 0.

Intercept but no time trend.

Intercept and time trend

Appendix B Dickey-Fuller Outputs

Std. Error 0.001266 0.001287 2.95E-07

t-Statistic -0.942559 0.588078 2.122258

Std. Error 0.001515 0.002364 3.58E-07

t-Statistic -1.040262 0.895856 1.601093

Std. Error 0.001606 0.002486 2.84E-07

t-Statistic -1.405812 1.565804 -2.505981

Std. Error 0.001579 0.002597 4.79E-07

t-Statistic -1.437383 1.568516 -1.833415

Std. Error 0.002302 0.289341 4.09E-05

t-Statistic -2.093804 2.114729 -1.387103

Appendix C Calculating the RSI

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