Through various stages, beginning as early as November 1967 and ending in March 1973, the major industrial countries shifted from fixed to flexible exchange rates. Under the flexible exchange rate regime of the 1970s, the major currency exchange markets experienced continuous and sometimes dramatic fluctuations. Exchange rates have appreciated and then depreciated by twenty percent or more in a single year. Price variation of a currency by as much as two percent or more within a single day was not uncommon. In the light of this experience, serious and fundamental disagreement about how well the floating exchange rates have served the needs of international finance have arisen. A large number of studies have been done on the floating exchange regime since 1973. While the majority of the studies focusses on the experience of the 1970s, a number have also studied the floating rates of the 1920s to substantiate or refute some of the hypothesis that have been forwarded. However, only one study known to the author has examined the efficiency of the foreign exchange market of a developing country . This study takes another step towards that direction.
The original intention of the thesis was to study both the foreign exchange markets of Singapore and Hongkong. They are the two of three foreign exchange markets in developing countries that have been identified by Blejer and Khan (1980a) as being sufficiently developed and sophisticated to qualify as candidates for study . However, because of the great difficulty in obtaining data for the Hongkong forward market, we have thus to be contented with a study of the Singapore market alone. The more conventional tests conducted have in part been done by Blejer and Khan. We repeated some of their tests for a longer period of study. However, while Blejer and Khan only examined the one-month forward market, this thesis studies the three-month forward market as well. This study would seem to be the first to apply the more sophisticated Hansen and Hodrick technique, and the variance-bounds method, to data from a developing country. It would also seem to be also the first to test the forward exchange market of a developing country for semi-strong market efficiency.
The major part of the thesis will focus on the test of market efficiency based on the asset pricing model. We therefore begin with a discussion of the theory of asset prices and the ability of the model in explaining some of the observed empirical regularities of the foreign exchange market in the next chapter. Chapter 3 reviews some of the existing literature on foreign exchange market efficiency based on the asset pricing approach. In Chapter 4 we provide some information on the institutions and legislation that influence the foreign exchange market of Singapore. We also compare some of the empirical regularities observed in the Singapore market with that of the markets of the more developed countries. The most important chapters of the thesis are Chapters 5 and 6 where the models of foreign exchange rate determination are tested empirically. Chapter 5 comprises the tests of the efficiency of the Singapore foreign exchange market based on the theory of asset prices. In Chapter 6 we take a look at the monetary model of exchange rate determination. The objective of the chapter is to test whether the monetary model is able to account for the observed volatility of the exchange rates observed during the period of study. It is in this chapter that we introduce the newly-developed variance-bounds technique. The final chapter discusses the implications of the findings of the thesis.
The efficiency of the foreign exchange market based on the theory of asset prices is an expanding area of research in both finance and macroeconomics. The variance-bounds test which is a joint test of rational expectations and various economic models has also gained widespread popularity since its introduction three years ago. It is thus desirable that the two models of market efficiency be tested over a wide range of data. The Singapore market was chosen in this case because it represents an expanding market for trade and international finance. A study of the efficiency of its foreign exchange market is important, for an efficient market is instrumental to its growth as a centre of trade and international finance, particularly as the centre of the Asian Currency Market. Business decisions such as whether to hedge existing investments or adopt an open position hinge upon the functioning of an efficient market and the speed and accuracy in which prices adjust to reflect all relevant information available. If the market is inefficient, businesses may find it profitable to engage the services of professional forecasting agencies which may provide a superior estimate of future spot exchange rates.
It is thus hoped that this study will provide additional insights to the relevance of the above mentioned models as models of foreign exchange rate determination. In addition, the findings may lead to a better understanding of the functioning of the foreign exchange market of a developing country vis-a-vis those of developed countries. Finally, the results will contribute towards the study of the potential of Singapore as a centre of international fund management.
1. Actually two studies were published by Blejer and Khan (1980a and b). However, the 1980b study is just a summary of the longer 1980a study done at the International Monetary Fund.
2. The third country is Bahrain.