Contrary to the efficient market hypothesis, can the management of technical analysis generate profits in the foreign exchange markets?

Abstract

The Efficient Market Hypothesis has been subject to great debate amongst many practitioners and academics who either vouch that the Forex markets are informationally efficient or those that believe that trading through technical analysis can generate profitable returns. The purpose of this study is to test the weak form efficient market hypothesis through the use of technical analysis within three currency pairs, EURUSD, EURGBP and EURNOK. This is designed by conducting an array of trading strategies, using different technical indicators in order to generate trading signals to buy and sell the markets. The efficiency of these indicators are gauged based on the risk adjusted profitable returns in excess over a rate of return from an asset generally considered to be risk free i.e. 10yr U.S. Treasury bond. The general findings indicate that a number of indicators generate a profitable return, upon some of which are also statistically significant based on the Wilcox Ranked Sign Test. However, the key findings is that the EURUSD is the currency pair which rendered the largest amount of profits and has the largest amount of trading opportunities, followed by EURNOK and lastly EURGBP. The evidence pertaining towards Japanese candlestick patterns is particularly powerful in terms of the amounts of profits made. The Bearish Engulfing candlestick pattern was seen to be the most profitable strategy in all currency pairs. The implications of this study are 1) Provides grounds for those who vouch for the use of technical analysis, that trading the latter form of analysis is an effective way to generate abnormal returns. 2) Illiquid currencies can provide larger trading opportunities than more frequently traded currency pairs. 3) Through the notion of rejecting the weak form efficient market hypothesis and inadvertently vouch for being able to predict the markets, both retail traders and multinational corporations can use this fact in terms of their hedging strategies looking forward. Moreover, this also provides further power to multinational corporations wishing to invest a particular country with a foreign currency, as they can use their prediction of the market direction in order to build a market view and thus make a sounder decision regarding the feasibility of the entire foreign investment.

All in all this study concludes that the markets are inefficient and technical analysis does have predictive power to beat the markets.