Baharumshah, Ahmad Zubaidi

Tan, Hui Boon

Universiti Putra Malaysia Institutional Repository

FOR Category F20100: Social SciencesON CONVERGENCE OF THE FOREIGN EXCHANGEMARKET: SOME EMPIRICAL EVIDENCE BASED ONTIME AND FREQUENCY-DOMAIN ANALYSISAhmad Zubaidi Baharumshah and Hui Boon TanFaculty of Economics and ManagementUniversiti Putra Malaysia, 43400 UPM, Serdang, Selangor,MalaysiaKeywords: foreign exchange market, cointegration,forward rates, spot rates.IntroductionThis paper investigates comovements and predictability offoreign currencies in the Malaysia for the period January1990 to June 1994. Weekly observation of the spot exchangerates, one- and two month forward exchange rates series: USDollar (US), Pound Sterling (BP), Deutsche Mark (DM),Japanese Yen (JY) and Singapore Dollar (SD) are utilized inthe analysis. Malaysia's foreign exchange market has grownrapidly since the implementation of the floating exchangerate regime in 1976. The spectacular development in the cur-rency market are due to factors such as liberalisation of ex-change rate controls, rapid inflows of foreign investments,opening of financial markets and improvements in telecom-munication facilities. There is no restrictions placed inhedging of currency exposures so long as the transactions aretrade related. Dealings in the currency market is still domi-nated by spot transactions with major proportion of transac-tion in of the forward market is interbank. The currenciestraded are mainly in US dollar, Singapore dollar, PoundSterling, Deutsche Mark and Japanese Yen.Materials and MethodsThis study addressed the issue of market efficiency by util-izing two econometric techniques: Johansen procedure andspectral analysis. Both the Augmented Dickey-Fuller (ADF)and Phillip Perron (PP) were utilised in this study to deter-mine the time series properties of the exchange rate series.The unit root tests were conducted first on level and then onfirst-difference of the variables. We apply the Johansen andJoselius (1990) multivariate trace and maximum eigenvaluetests on the five exchange rates to test for the long-run rela-tionship. Akaike's formal prediction error and Sim's (1980)likelihood ratio test are employed in the analysis to deter-mine the appropriate lag length for the vector autoregressive(VAR) model. Next, we employed the spectral analysis toexamine the behaviour of the exchange rates movements as acomplement to the Johansen test procedure.Results and DiscussionThe results of the unit root test confirmed that an 1(1) pres-entation is reasonable for all spot and forward rates. The re-sults.are consistent with those reported earlier by Baillie andBollerslev (1989a), Lai and Lai (1991) and Copeland (1991),among others. The results Johansen multivariate cointegra-tion analysis may be summarised as follows. First, both thetrace and maximum eigenvalue test yield identical results:The null hypothesis of zero cointegrating vector (r=O) is re-jected using the 95% critical value in all cases except one-The Japanese Yen. However, the test fails to reject the nullhypothesis in r ~ I, against the alternative r ~ 2 for variousmaturities of US, BP, JY DM and SD. Overall, our resultsfound that spot and forward rates shared a common stochas-tic trend, that is, they are cointegrated.ConclusionsResults obtained from this study show that forward rates andthe actual spot rates is cointegrated and forward prices canexplain movements in spot prices. However, our study showsthat the use of forward rates as predictor of future spot ratesshould be considered only with utmost care since the resultof study cast doubts on the usefulness of forward rates as apredictor for future rates. Thus, the evidence provided in thisstudy in general is not favourable to the joint hypothesis ofmarket efficiency and no risk premium. Intuitively, the re-sults appear sensible since the forward market is only of re-cent origin and is still at its infancy stage. The liquidityproblems could partially accounts for the inefficient nature ofthe forward market. We also cannot rule out that the presenceof risk premium and high transaction costs as possible rea-sons for the rejection of EMH in the Malaysian foreign ex-change market. Clearly, this is beyond the scope of the pres-ent study.ReferencesBaillie, R.T. and Bollerslev, T. 1989a. Common Stochastic Trends inA System of Exchange Rates, Journal of Finance. 44: 167-181.Copeland, L. 1991. Cointegration Test of Daily Foreign ExchangeData, Oxford Bulletin of Economics and Statistics. 53: 185-198.Johansen, S. and Juselius, K. 1990. The Full Information MaximumLikelihood Procedure for Inference on Cointegration with Appli-cation, Oxford Bulletin of Economics and Statistics. 52: 169-210.Lai, K.S. and Lai,M. 1991. A Cointegraion Test for Market Effi-ciency, Journal of Futures Markets. 11(5): 567-575.Sims, C.A. 1980. Macroeconomics and Reality, Econometrica. 48:1-49.Supponed by lRPA Grant 05-02-04-0002337

On convergence of the foreign exchange market: some empirical evidence based on time and frequency-domain analysis

http://psasir.upm.edu.my/43082/1/On%20convergence%20of%20the%20foreign%20exchange%20market%20Some%20empirical%20evidence%20based%20on%20time%20and%20frequency-domain%20analysis.pdf

On convergence of the foreign exchange market: some empirical evidence based on time and frequency-domain analysis

Abstract

Similar works

Full text

Available Versions

Universiti Putra Malaysia Institutional Repository