Academic journal article The Lahore Journal of Economics

The Efficiency of Foreign Exchange Markets in Pakistan: An Empirical Analysis

Academic journal article The Lahore Journal of Economics

The Efficiency of Foreign Exchange Markets in Pakistan: An Empirical Analysis

Article excerpt

1. Introduction

The importance of the foreign exchange market is fairly evident in today's globalized world, and the exchange rate literature has produced a rich body of empirical research that addresses three key questions:

1. How efficient is the foreign exchange market?

2. Which is the most suitable model for exchange rate movements?

3. How can we model the expectations of foreign exchange market participants?

The objective of this study is to answer these questions empirically by establishing the relationship between the spot exchange rate and forward exchange rate based on the regression analyses put forward by Frenkel (1980) and Levich (1979). Our study is with reference to Pakistan and also investigates the efficiency of its foreign exchange market. In this context, "efficiency" means that the market's players have processed all the available information at the time of determining the forward exchange rate. The forward exchange rate should then be able to predict the future spot rate with reasonable accuracy. On the other hand, if the future spot rate deviates from the forward rate, this will lead to inefficiency or imperfection.

In Pakistan's case, the most significant issue is to determine whether or not the financial markets can efficiently allocate economic resources based on the information available. The exchange rate of the Pakistani rupee (PKR) is influenced chiefly by the market mechanism and the forward exchange rate is determined by the interaction of demand and supply. The intercession of the State Bank of Pakistan (SBP) in the currency market does not have a significant impact on the determination of the forward exchange rate. Its only role is to smooth out any foreign exchange market shakiness.

The determinants of the forward exchange rate include the interest rate differential of the two economies in the interbank market, the current account surplus of imports in relation to exports, and capital receipts. When determining the forward exchange rate, market players are assumed to have complete information on these factors and to consider all the available information at that time. Thus, the forward exchange rate encompasses all the available information relating to these factors.

A number of tests help determine the efficiency of the foreign exchange market, of which the efficient market hypothesis (EMH) is the most useful (Roberts, 1967). The EMH is considered the cornerstone of modern foreign exchange theory, and it takes into account both the rational expectations hypothesis and the risk-neutral behavior of investing agents. The EMH holds that, in an efficient market, price will reflect the available information fully (Fama, 1984). It also considers issues related to reliability, variance, seasonality, volatility, and market instability. Studying all these issues enables market analysts to gauge the efficiency of a country's financial market.

Market efficiency with respect to the EMH is classified as weak, semi-strong, or strong. In its weak form, efficiency implies that the information available reflects only the history of prices or returns. Semi- strong efficiency suggests that prices reflect the information available to all market individuals. In its strong form, efficiency means that prices reflect inside information in addition to past prices and publicly available information (Fama, 1970, 1991).

Sections 2 and 3 review the theoretical and empirical aspects of the efficiency of the foreign exchange market. Sections 4 and 5 present the model and variables used. Section 6 provides a detailed empirical analysis. Sections 7 and 8 conclude the study and point out some research limitations.

2. Review of the Literature

Earlier studies on the EMH involved conducting regression analyses by taking the logs of the future spot exchange rate and current forward exchange rate. Their results suggested that the forward exchange rate was an unbiased predictor of the future spot exchange rate (Frenkel, 1980; Levich 1979). …

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