Assessing Market Efficiency and Volatility of Exchange Rates in South Africa and United Kingdom: Analysis Using Hurst Exponent

By Yaya, OlaOluwa S.; Saka, Luqman et al. | The Journal of Developing Areas, Winter 2019 | Go to article overview

Assessing Market Efficiency and Volatility of Exchange Rates in South Africa and United Kingdom: Analysis Using Hurst Exponent


Yaya, OlaOluwa S., Saka, Luqman, Akanbi, Olawale B., The Journal of Developing Areas


(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

This paper attempts to explain the propagation of shocks to exchange rates by assessing the level of market efficiency and volatility between two economies that trade together. Two important features in exchange rates series are the possibility of random walk movements in the log-returns of the asset series, as noted in Fama (1965), and the possibility of returns being characterized by periods of tranquility and volatility as noted in Mandelbrot (1963). These features make the analysis of exchange rates to be important in the design of policy, portfolio and risk management whenever international trade and finance is discussed. As defined by Fama (1970), the actual price of an asset is a good estimate of its intrinsic value at the market, that is, the market does not allow investors to make extraordinary profit from a current investment strategy. Thus, future returns are unpredictable in an efficient market. In this case, the direction and rates of Foreign Exchange (FOREX) is unpredictable since FOREX investors must not profit from already available information. Market efficiency is therefore the main guide for investors and portfolio managers in the sense that it assures their confidence in market valuation. The three levels of efficiency are classified in Fama (1991) based on the information used in defining them. Fama (1991) noted that a market is in the weak form of efficiency when only the past and current market values are considered, that is, past returns cannot predict the current returns. In the semi-strong efficiency, market values take into consideration all available information to the public. The strong efficiency form states that market values contain all publicly and privately available information. The possibility of assets market efficiency has been discussed critically in empirical and theoretical literature particularly the tendency of the markets to be efficient after the Global Financial Crisis (see Cont, 2001; Elton et al., 2003, Malkiel, 2003). In an inefficient market, it is therefore difficult for investors or portfolio managers to diversify their portfolio since forecasts of future market are difficult to obtain. Portfolio diversification requires market investment that are efficient enough to predict, and the influence of spill from one market to the other is very important since this allows portfolio managers to manage the investment at hand.

In carrying out this study, the random walk hypothesis is then tested by means of Hurst exponent as first proposed in Mandelbrot (1982) after the initial work of Hurst (1951). Other alternative estimators for Hurst exponents, with further refinements are proposed in Geweke and Porter-Hudak (1983), Robinson (1994), Robinson(1995a,b), Velasco(1999), Phillips and Shimotsu(2004, 2005) and Abadir et al.(2007). The estimation procedures for the exponent are semi-parametrically and parametrically specified. We make disparity between the two markets by using the newly proposed Efficiency Index (EI) by Kristoufek and Vosvrda (2013a, b). The measure takes into consideration long-term and short-term memory of the correlation structure at the different market phases. Thus, we applied the modified version of this index for measuring the disparity in the exchange rate markets volatility. Specifically, this paper aimed at investigating the level of market efficiency and volatility at different market phases of US dollars exchange rates to South African Rand and British Pound using the random walk hypothesis theory.

This work was motivated based on many reasons: (1), In terms of importation and exportation of goods, South Africa is the largest trade partner in Africa for the United Kingdom, taking a lion share in the total trade of 68.3% from Africa in 2014. The two countries also share common interest in the promotion of international trading system (see Weimer and Vines, 2011). (2), in 2014, South Africa received quite the largest UK Foreign Direct Investment (FDI) of about 30% of total UK FDI in the Africa, so this makes the country a giant in Africa in terms of international trade. …

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