| dc.description.abstract | The aim of this study was to establish the efficiency of foreign exchange markets in Kenya using the rational expectations approach. The study was based on the null hypothesis that the economic agents are rational. Assuming that market participants are rational, the expected change in the exchange rate should differ from the actual change only by a rational expectations forecast error. Historical data for the monthly (average) spot exchange rate and the three-month forward premiums for the Euro, the Sterling Pound, the US Dollar, and the two East African currencies were obtained from the Central Bank of Kenya based on all banking institutions that actively engage in foreign exchange business. The sample period was from November 1993 to June 2006. All the exchange rates were expressed in Kenya Shillings (Kshs) per unit of foreign currency. The US monthly averages for the 91-Day T-BILL rates were used in computing the forward rates for each of the currencies.
The key findings revealed that the forward rates are not unbiased predictors of the future spot rates for the Euro, the Sterling Pound, the US Dollar, the Uganda Shilling, and the Tanzanian Shilling. Secondly, the findings established that the participants in the foreign currency markets in Kenya are not risk-neutral and are not rational; a phenomenon that was reinforced by the presence of auto-correlations. The results of the study were consistent with the hypothesis that the forward exchange rates are not unbiased predictors of the future spot rates. This agreed with previous empirical works (Frankel, 1980; Fama 1984; Bekaert and Hodrick, 1993) which rejected the v
efficient markets hypothesis under risk-neutrality on the basis of regressing the applicable model for various currencies.
Under the presence of efficiency in the foreign exchange market, the forward exchange rate should be an unbiased predictor for the future spot rate. The rejection of the efficiency hypothesis implies the presence of unexploited profit opportunities for those who participate in exchange rate transactions in the Kenyan FOREX markets. In other words, the general conclusion emerging from the extensive empirical analysis is that the forward exchange rate is not an unbiased predictor of the future spot and the presence of a risk premium is apparent. The failure of the currency markets to be
‘weak form’ efficient also indicates that not all price information is fully reflected in currency prices, thus implying that the current price changes cannot be predicted from past prices. As a result, the participants in the FOREX markets in Kenya conduct their transactions on the basis of speculation rather than on prediction of future market behaviour based on the past or current performance of respective currency markets. | en |
