Determining the Efficiency of the Foreign Exchange Market in Kenya

Abstract

The repealing of the Exchange Control Act in 1995 was the first step towards a liberalized foreign exchange market. This also saw the entry of foreign exchange Bureaus in the market. This study was carried out to determine the efficiency of the foreign exchange market in Kenya which is dominated by banks and bureaus. The main objective was to find out whether it was possible for an arbitrageur to make profits through locational and triangular arbitrage. Secondary data in the form of daily closing counter foreign exchange rates for six banks and fifty seven bureaus were obtained from the Central Bank of Kenya and analyzed using chi- square and line graphs. To determine locational arbitrage the highest buying price of the particular currency was obtained and from it the lowest selling price was deducted. To determine triangular arbitrage, the cross rate between the Euro and the Dollar was computed. The computed cross rate was then compared with the actual exchange rate of the two currencies. If the computed cross rate is greater than the actual exchange rate, then there was an opportunity for triangular arbitrage. Having identified the opportunity for triangular arbitrage, one thousand Kenya shilling was used to purchase the overvalued currency, which was then used to purchase the undervalued currency. Finally the undervalued currency was converted back to Kenya shilling. The difference between the final amount of Kenya shillings and the amount at the beginning of the transaction represented arbitrage profits. 11 The research concludes that the foreign exchange market is generally inefficient due to the existence of arbitrage opportunities for both bureaus and banks. Higher arbitrage profits could be obtained among bureaus than banks. This could be due to the fact that banks may be able to better disseminate information amongst themselves than bureaus may.