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Christopher Bellgard Dr Peter Goldschmidt
cbellgar@ecel.uwa.edu.au pgold@ecel.uwa.edu.au
Abstract
This research paper discusses aspects of foreign exchange rate forecasting in terms of the
Random Walk Hypothesis (RWH). The following forecasting techniques were evaluated for
Average and Artificial Neural Networks. Using recent Australian-US dollar data, the
research examined the implications, of data frequency and linearity, on the RWH.
The research intention is, consequently, to advance foreign exchange rate research,
the phenomenal size of the foreign exchange rate market; the Bank of International
The paper discusses how the RWH was initially discounted through statistical insignificance.
profitability (Lee, 1996). Consequently, all model types – including random walks – were
ultimately compared through a trading simulation. Being based on a position-taking rule, the
In direct conflict with the RWH, the trading simulation was able to surpass a 30% annualised
return, within sample. This was achieved by capturing and capitalising upon intrinsic non-
linearities. That is, foreign exchange rates exhibit complex (non-linear) patterns that may be
profitably exploited.
This paper adds to an increasing body of evidence against the RWH. Evidence, to date,
• ANNs, including hybrid ANNs (Tan, 1995), can yield a higher profit than linear
• Technical analysis is widely used by many investors (Hawley et al., 1993; Mehta,
1995).
Keywords
exchange.
Introduction
This research paper considers the Random Walk Hypothesis (RWH) through the effect of
linearity and forecasts of different data frequencies. Linear and non-linear models were
3.
evaluated on various linear and non-linear criteria. In accordance with the aim, models were
introduced further non-linearity. The RWH is addressed through the consideration of non-
linear models.
Background
This paper is derived from Bellgard (1998). In this research, one null hypothesis was: Foreign
exchange rate data exhibits complex (non-linear) patterns that may be profitably exploited.
The research question was: Are artificial neural networks superior to simple linear modelling
the objective was to investigate various modelling techniques used for forecasting foreign
exchange (FX) rates. For example, Random Walks (RWs), Exponential Smoothing,
(ANNs). The aim was to identify the most profitable model – if any – at each frequency. It
was expected that linearity and non-linearity would influence such identification. This would,
Data set
For reasons of reliability and interest, the data set comprised half-hourly observations of the
United States Dollar and Australian Dollar (USD/AUD) FX rate during 1996. Forecasting of
this particular FX rate has, incidentally, received much less research attention than the two
most traded currencies (USD and Deutschmark) – recent exceptions include Manzur (1993)
From the half-hourly data set, hourly and daily observations were extracted. The first
difference was then taken for each frequency; earlier studies have found that the direction of
the forecast is more important than the actual forecast in determining the profitability of a
model (Tsoi et al., 1993a; Tsoi et al., 1993b; Sinha and Tan, 1994).
Linearity
Linearity is the property of having one dimension (Oxford Dictionary, 1992). The term is also
used to “…express the concept that the model possesses the properties of additivity and
homogeneity” (Hair et al., 1998) meaning that a change in one variable causes a proportional
change in another variable. It follows that non-linearity is the property of having more than
one dimension. Profitably trading on such intrinsic data properties is directly relevant to the
RWH.
Random walks
A RW is a time series whose period to period changes, or first differences, are stationary
(Newbold and Bos, 1994). A time series is stationary if its mean and variance are both
constant across time and its autocorrelation1 depends only on the lag. Hence, for a stationary
time series, mean, variance and autocorrelation are all independent of time (Everett, 1997).
Additionally, the proportional changes of RWs, in a short period of time, are normally
distributed (Hull, 1995). That is, the direction and size of changes are independently and
randomly chosen from the normal distribution. The best prediction is no change; this is
1
Correlation between a time series and the same series with a given lag.
5.
The Efficient Markets Hypothesis (EMH)2 states that, in an efficient market, asset prices fully
reflect all available information about the asset; investors cannot consistently earn abnormal
returns (Peirson et al., 1995). The weak form considers only past information (i.e. historical
prices). It implies that prices follow a RW in which successive price changes have zero
correlation (Trippi and Lee, 1996). This subset of the EMH is known as the RWH (Peirson et
al., 1995). Furthermore, the EMH does not support technical analysis.
Due to market efficiency, FX rates are widely viewed to be best explained as RWs (Diebold
and Nason, 1990). In addition, research by Meese and Rogoff (1983) and Hogan (1986)
supports the superiority, of RWs, over certain estimated models, like ARIMA. The ARIMA
modelling approach (Box and Jenkins, 1970), however, is more general because it includes
RWs.
The weak EMH is mitigated by bounded rationality arguments (Simon, 1955; Simon, 1982).
Such arguments hold that efficiency is restricted by human information processing which is
inherently limited. New processing technology (such as ANNs) provides profit opportunities
for the holder of that technology, effectively providing a form of insider information.
However, the EMH implies that increased availability, of the technology, will rapidly erode
its advantages – until they disappear. Meanwhile, “…in view of the relative novelty of neural
networks, and the implications of bounded rationality, it is at least conceivable that previously
2
Fama (1970).
6.
undetected regularities exist in historical asset price data, and that such regularities may yet
The study of kurtosis provides preliminary evidence against the RWH for FX rates. Kurtosis
normal distribution with the same mean and standard deviation. A leptokurtic distribution’s
tails are fatter – and a platykurtic distribution’s tails are thinner – than those of a
Figure 1, below.
Normal
Leptokurtic
Platykurtic
FX rate changes tend to be leptokurtic (Hsieh, 1988; Contingency Analysis, 1997). This
means that dramatic market moves occur with greater frequency than is predicted by the
normal distribution. That is, large changes (those at the tails) have a greater probability than
they would have under a normal distribution. The existence of leptokurtic FX rates provides
Normality (stationarity), of first differences, can be assessed quantifiably with statistical tests.
The adjusted Box-Pierce Q-Statistic indicates the overall adequacy of the RW model
M = number of autocorrelations
M
r 2 (k )
then: Q = n(n + 2)∑
k =1 n − k
and: Q ~ χ2 M-K
Hence, Q has a chi-squared (χ2 ) distribution with M-K degrees of freedom. The observed
value of Q is significant (and the data non-stationary) if it is less than the critical (tabulated)
(with at least 95% certainty) that the data does not follow a RW.
Corresponding to the aim, first differences were used as the basis of prediction. The predicted
direction of price movements was more relevant, to the position-taking nature of the trading
simulation, than the actual price prediction. For completeness, however, the Q-test was
applied to the prices and price changes of the data sets. The Q-test results are shown below in
Table 1.
8.
Data Frequency
Half-Hourly Hourly Daily
Critical Value 443.4 320.0 74.5
Prices
Observed Value 1173.1 555.9 79.6
The observed values of the price changes are substantially higher than those of the prices.
That is, price changes are more stationary than prices. More importantly, in all cases,
observed chi-square values exceed critical values, especially at higher frequencies. Hence,
1996 USD/AUD FX prices (and price changes) fail the Box-Pierce Q-Test. 1996 USD/AUD
This finding is replicated by the normality test macro in SPSS (refer to Figures 2, 3 and 4).
The Kolmogorov-Smirnov Test is similar to the Box-Pierce Q-Test; the “sig” value is the
probability that price changes follow a normal distribution. A sig value of less than 5% means
that price changes are not normally distributed, and that prices do not follow a RW.
Visually, the histogram of normally distributed input should be very close to the normal
curve. In all cases, the histogram is substantially taller. This is consistent with the leptokurtic
Cases
Valid Missing Total
N Percent N Percent N Percent
UA30D 17567 100.0% 0 .0% 17567 100.0%
Tests of Normality
a
Kolmogorov-Smirnov
Statistic df Sig.
UA30D .164 17567 .000
a. Lilliefors Significance Correction
Histogram
10000
8000
6000
4000
Frequency
0 N = 17567.00
-.0
-.0
-.0
-.0
-.0
-.0
-.0
-.0
.00
.00
.00
.00
.00
.00
.01
.01
11
10
08
07
05
03
02
00
08
23
39
55
70
86
02
17
7
UA30D
2 10
0 0
Dev from Normal
Expected Normal
-2 -10
-4 -20
-.02 -.01 0.00 .01 .02 -.02 -.01 0.00 .01 .02
Cases
Valid Missing Total
N Percent N Percent N Percent
UA60D 8783 100.0% 0 .0% 8783 100.0%
Tests of Normality
a
Kolmogorov-Smirnov
Statistic df Sig.
UA60D .140 8783 .000
a. Lilliefors Significance Correction
Histogram
5000
4000
3000
2000
Frequency
0 N = 8783.00
-.0
-.0
-.0
-.0
-.0
.00
.00
.00
.00
.01
11
09
06
04
01
09
34
59
84
09
6
UA60D
2 10
0 0
Dev from Normal
Expected Normal
-2 -10
-4 -20
-.02 -.01 0.00 .01 .02 -.02 -.01 0.00 .01 .02
Cases
Valid Missing Total
N Percent N Percent N Percent
UA366D 365 100.0% 0 .0% 365 100.0%
Tests of Normality
a
Kolmogorov-Smirnov
Statistic df Sig.
UA366D .123 365 .000
a. Lilliefors Significance Correction
Histogram
140
120
100
80
60
40
Frequency
0 N = 365.00
-.0
-.0
-.0
-.0
-.0
-.0
-.0
-.0
-.0
.00
.00
.00
.00
.01
21
18
16
13
11
08
06
03
01
12
37
62
88
12
3
UA366D
1
2
0
1
-1
0
-2
Dev from Normal
Expected Normal
-1
-3
-2
-4
-3 -5
-.03 -.02 -.01 0.00 .01 .02 -.03 -.02 -.01 0.00 .01 .02
Normally distributed data should closely follow the straight line of the Normal Plot. It should
not exhibit a pattern in the Detrended Normal Plot. Clearly, the histogram and plots are
consistent with the Kolmogorov-Smirnov Normality Test in asserting that price changes are
not normally distributed. Furthermore, the S-shape Normal Plots suggest that high-frequency
FX prices are further away from a RW than low-frequency FX prices (the daily data’s Normal
Plot is straighter).
Based on the above evidence, it is not surprising that RW models were statistically
insignificant at each frequency. However, given the non-linearity of the trading simulation,
RWs were not discarded from the comparison. The logical rationale for this was that
statistical insignificance may not have a bearing on profitability, when considering non-
linearities. This is because statistical measures of accuracy do not always have a direct
Comparing models
Models were initially compared using theoretical (linear) measures such as root mean squared
error (RMSE), mean absolute error (MAE) and information coefficient (Tr ). Tr is also known
3
Diagnosed with an ARIMA modelling algorithm explained in Bellgard and Goldschmidt (1999a).
13.
All ARIMA models ranked first. This reflects the statistical significance of the ARIMA
models and the linearity of the measures. RNNs were ranked close to RWs and exponential
smoothing. The linear measures did not account for the non-linearity of the RNN models.
correctly predicted direction changes. Individual results are not important, except to report
that:
Considering all of the preceding measures, the findings so far suggest that:
Trading simulation
To make it more realistic, the trading simulation incorporated filters and transaction costs
(both measured in FX points). Filters expanded the range of available models. A market
maker with low transaction costs requires 60% correct trades to run a profitable FX desk
(Grabbe, 1996). Hence, a model was deemed “acceptable” if it returned a net positive gain,
14.
subject to having winning trades at least 60% of the time. At each frequency, the three most
Total %
Model Filter Annualised Win
Gain
1st ARIMA(2,0,2) 0.0010 15.3% 100.0
2nd (none)
3rd (none)
Conclusion
This study conflicts with the RWH and, hence, with the weak form of the EMH. This
apparent discovery adds to the increasing body of evidence against the RWH. “The pertinent
view, in economic literature, that exchange rates follow a random walk, has been dismissed
by recent empirical work. There is now strong evidence that exchange rate returns are not
independent of past changes.” (Tenti, 1996). This body of evidence includes the following:
15.
• ANNs, including hybrid ANNs (Tan, 1995), can yield a higher profit than linear
• Technical analysis is widely used by many investors (Hawley et al., 1993; Mehta,
1995).
16.
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The data set was derived from “HFDF96” which was purchased from Olsen and Associates,
Switzerland. “SPSS for Windows” is a trademark of SPSS Inc.