Using PPP deviations as a trading rule : an indirect joint test of PPP and foreign exchange market efficiency

In this thesis an international investment filter rule is used to test both the tendency for Purchasing Power Parity (PPP) to hold in the long run and the hypothesis of foreign exchange market efficiency for the four most actively traded currencies in the world vis-a-vis the United States dollar: the British pound, the Japanese yen, the Germany mark, and the Canadian dollar. One way to examine whether there is a tendency for PPP to hold in the long run and whether the foreign exchange market is efficient, is to place more money in the 'undervalued' currency according to PPP deviations or to invest according to PPP deviations, putting more money into interest bearing securities in the 'undervalued' currency, the more this currency is undervalued. The return can then be compared with a reference rule which does not use this filter, but instead puts an equal value of money into the currencies or the securities of each country. This thesis has produced three results. First, using the PPP filter in the exchange money market yields no significantly abnormal rate of return compared with the reference rule. The result suggests that we can not reject the hypothesis that the tendency for PPP to hold in the long run does not exist. Second, using the PPP filter to invest in securities also yields no significantly higher rate of return compared with the reference rule. And third, when comparing the domestic (or foreign) interest rates with the rates of return for the domestic (or foreign) investor who uses the PPP filter, there is no significant difference between these rates in the long run. The last two results suggest that we can not reject the hypothesis that the foreign exchange-market is efficient.Business, Sauder School ofGraduat