Should Foreign Exchange Rates Follow a Random Walk?
Although the efficient market hypothesis is usually applied to the stock market, it can also be used to show that foreign exchange rates, like stock prices, should generally follow a random walk. To see why this is the case, consider what would happen if people could predict that a currency would appreciate by 1% in the coming week. By buying this currency, they could earn a greater than 50% return at an annual rate, which is likely to be far above the equilibrium return for holding a currency. As a result, people would immediately buy the currency and bid up its current price, thereby reducing the expected return. The process would stop only when the predictable change in the exchange rate dropped to near zero so that the optimal forecast of the return no longer differed from the equilibrium return. Likewise, if people could predict that the currency would depreciate by 1% in the coming week, they would sell it until the predictable change in the exchange rate was again near zero. The efficient market hypothesis therefore implies that future changes in exchange rates should, for all practical purposes, be unpredictable; in other words, exchange rates should follow random walks. This is exactly what empirical evidence finds.7