Measuring excess-predictability of asset returns and market efficiency over time

We build on the predictability bounds of Huang and Zhou (2017) and Poti (2018) to develop an index of informational market inefficiency. This index takes values given by the levels of relative risk aversion (RRA) of the marginal investor such that, net of sampling error at a given confidence level, the observed predictability does not exceed the predictability bound. We demonstrate the usefulness of our index in a study of the predictability of forward exchange rates of currencies of emerging and developed economies from 1994 to 2016, to shed light on how the efficiency of currency markets has evolved over this time. We find widespread evidence of excess-predictability, hence currency market inefficiency, in the early part of the sample period and then at specific times, such as the recent global financial crisis. In the more recent part of the sample period, the evidence of excess-predictability is largely limited to emerging market currencies. (C) 2019 Elsevier B.V. All rights reserved.