An Investigation on the Efficiency of the Foreign Exchange Market in Kenya: the Rational Expectations Approach

Abstract

The aim of this investigation was to establish whether the forward rate is an unbiased predictor of the future spot exchange rate. The study was guided by three theories namely; Efficient Market Hypothesis, Arbitrage Pricing Theory and the Law of One Price Theory. Descriptive cross-sectional design was adopted for the study. Data was exclusively collected from a secondary source. The research centered on the foreign exchange markets under floating exchange rates beginning July 1999 to June 2016. Historical facts on the monthly (average) spot exchange rate and the three-month forward premiums for the British pound, the Euro, the US Dollar, and the selected currencies of the East African region were sourced from the Central Bank of Kenya. Regression analysis was conducted to determine the significance of the regression coefficients. From the findings, the study concluded that forward rates for all the five currencies (USD, GBP, EURO, UGSH and TZSH) have a positive and significant influence on future spot exchange rates. The study, therefore, concluded that forward rate is an unbiased predictor of the future spot exchange rate. This means therefore that the market is not efficient as per the investigation. From the findings, the study recommended that participants of the FOREX market should know when and when not to take advantage of the inefficiency in the FOREX market to make arbitrage profits. Further, the study recommended the need for scholars and academician to undertake more studies relating to the foreign exchange market. This is because; it is an area that has not been fully researched.