EFFICIENCY OF FOREIGN EXCHANGE MARKET OF SRI LANKA: SOME EMPIRICAL EVIDENCE

1.IntroductionFama (1970) identified three versions of the efficient market hypothesis (EMH). These three versions are known as (i) weak-form efficiency, (ii) semi-strong form efficiency and (iii) strong-form efficiency. According to the weak-form efficiency current foreign exchange rates reflect information available in past exchange rates. Therefore, current foreign exchange rates instantly adjust to reflect past information contained in the exchange rates. This means, a participant in the foreign exchange market cannot make use of past exchange rates to predict future exchange rates. Therefore, it is impossible for a participant in the foreign exchange market to make gains from foreign exchange transactions on a consistent basis.The semi-strong form of the efficient market hypothesis (EMH) implies that foreign exchange rates reflect not only the information in past exchange rates but also the information in other exchange rates and other publicly available information such as macroeconomic variables. Therefore, a speculator or an arbitrager in the foreign exchange market cannot use exchange rates other than the one we are concerned with and other publicly available information to predict future values of an exchange rate. Consequently, a speculator or an arbitrager is unable to devise any trading rule to make abnormal gains from foreign exchange transactions on a consistent basis.When a foreign exchange market is strong form efficiency it reflects both information contained in past exchange rates and publicly available information. In addition, it reflects inside information of a foreign exchange market. This implies that even a central bank official or other insider of the foreign exchange market cannot make abnormal gains in the foreign exchange market on a consistent basis on the basis of information available to them.According to Pilbeam (1992), the efficiency or inefficiency of a foreign exchange market has policy implications of importance. An inefficient foreign exchange market allows participants to develop a model that best predicts exchange rate movements. Therefore, participants of an inefficient foreign exchange market are able to engage in profitable foreign exchange transactions. An inefficient foreign exchange market also allows government authorities to determine the best way to influence exchange rates in order to reduce exchange rate volatility and provide an opportunity to evaluate the consequences of different economic policies. In contrast, government authorities need minimal intervention in an efficient foreign exchange market. Further the participants of an inefficient foreign exchange market are unable to make abnormal gains from foreign exchange transactions on a continuous basis.The objective of the current study is to test the validity of both the weak and semi-strong versions of the EMH to the foreign exchange market during the floating exchange rate regime using data from a more recent sample period and examine how results are sensitive to different econometric techniques.The paper is organized as follows. Section two provides an overview of the empirical literature, Section three provides an overview of the foreign exchange market of Sri Lanka. Section four outlines the methodology and data, empirical results are analyzed in Section five and the last section offers conclusions and policy implications.2. Review of LiteratureFama's original paper on the EMH received enormous attention from academics, particularly, those of the developed countries. This resulted in a plethora of studies on efficiency of foreign exchange markets in these countries using different analytical tools. Traditionally, researchers have applied three main approaches to test the efficiency of foreign exchange markets. The focus of these approaches was mainly on whether (a) a spot exchange rate for a currency behaves as a random walk or whether the foreign exchange market is weak-form efficient (b) the forward rate for a currency is an unbiased predictor of the future spot exchange rate for that currency or whether the foreign exchange market is semi-strong form efficient and (c) there are cointegrating relationships among several currencies or whether the foreign exchange market is semi-strong form efficient. …