Academic journal article Journal of Economic Cooperation & Development

Exchange Rate Volatility and Market Efficiency Evidence from Pakistan

Academic journal article Journal of Economic Cooperation & Development

Exchange Rate Volatility and Market Efficiency Evidence from Pakistan

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1. Introduction

The exchange rate is one of the important economic indicators which play a crucial role to determine the degree of competitiveness among economies because it has a strong impact on economic developments, foreign direct investment flows, international trade and capital mobility. It also affects firm profitability, price stability, and financial stability of a country (Benita and Lauterbach, 2007). It plays an important role in currency related derivative pricing and international capital budgeting and key input to investment, portfolio design and risk management.

Further, for stable economic conditions there is need of existence of an efficient foreign exchange market. According to Fama (1970), an efficient foreign exchange market is the one if exchange rates reflect all available relevant information. The exchange rates immediately absorb new information so that there exist no opportunities for investors to earn excess profits. There is efficient allocation of the resources as decisions are made on the basics of observed exchange rates by economic agents.

Exchange rate volatility in developing countries like Pakistan is very pervasive. In Pakistan, an extensive increase in the exchange rate volatility is seen in the recent years. This results in uncertainty and risk that adversely affect foreign exchange market agents as well as market efficiency in Pakistan. Market efficiency has sufficient condition that exchange rates fluctuate randomly or without any identifiable pattern i-e they follow a random walk. If foreign exchange market is efficient, abnormal profits cannot be earned from trading rules based on past returns. Therefore, exchange rate returns are unpredictable, and any technical analysis or statistical technique to predict future pattern of exchange rate returns based on past returns is impossible. Therefore, exchange rate volatility and market efficiency are important issues in Pakistan.

The conventional market efficiency tests e.g serial correlation test, unit root test, variance ratio test and runs test assume linear structure in the exchange rates returns generation process and are not able to capture non-linear behavior in exchange rate return series. Therefore, GARCH models are used to estimate exchange rates volatility and for testing market efficiency. These models are able to capture characteristics of exchange rate returns that include fat tails, peakedness (leptokurtosis), skewness and volatility clustering.

This paper empirically investigates the volatility dynamics of Pak Rupee exchange rates and its effects on market efficiency. In this paper, GARCH models are used and monthly data on Pak Rupee exchange rates in the terms of major currencies (US Dollar, British Pound, Canadian Dollar and Japanese Yen) are taken from April, 1982 to June, 2012 for a total of 363 monthly observations are used.

The structure of paper is as follows: Section II shows the literature review. Section III presents the methodology. Section IV presents empirical analysis. Section V provides conclusion.

2. Literature Review

A considerable amount of research is focused on modelling volatility in foreign exchange markets. ARCH model proposed by Engle (1982) is designed to incorporate conditional variance in order to model the financial volatility. For this purpose, conditional variance is modelled as function of past square error terms. GARCH model proposed by Bollerslev (1986) is introduced which consider conditional variance depends not only on past square error term but also on its past conditional variance.

The use of ARCH/GARCH models and its extensions and modifications in modelling and forecasting foreign exchange market volatility is now very common in finance and economics, such as French et at. (1987), Lau et at. (1990), Franses andVan Dijk (1996) and Choo et al. (1999). On the other hand, the ARCH model was first applied in modeling the currency exchange rate by Hsieh (1988). …

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