FOREIGN EXCHANGE MARKET EFFICIENCY: ASIA-PACIFIC FOCUS WONG YUEN MENG THESIS SUBMITTED IN FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY FACULTY OF BUSINESS AND ACCOUNTANCY UNIVERSITY OF MALAYA KUALA LUMPUR 2013 ABSTRACT The foreign exchange market is the largest financial market in the world. According to the Bank for International Settlements (BIS) 2010 Triennial Central Bank Survey, the annual turnover in the foreign exchange markets is estimated to be around USD1,000 trillion. Hence, a slight distortion in foreign exchange market efficiency represents a significant profit opportunity. From the review of market efficiency literature, it is found that the empirical evidence in respect of market efficiency has been mixed and inconclusive. In addition, there is also a serious neglect in the study of foreign exchange market efficiency especially in the Asia-Pacific region. This thesis investigates foreign exchange market efficiency using the Asia-Pacific currencies. We adopt the forward unbiasedness hypothesis and an event-study analysis in the investigation of the foreign exchange market efficiency. To the best of our knowledge, this is the first study which employs these two approaches jointly in a single research using the Asia-Pacific currencies as the core sample. This combination provides us with a more comprehensive view on the state of foreign exchange market efficiency. Ultimately, we find that the Asia-Pacific foreign exchange markets are generally efficient over the whole sample period but with some signs of market inefficiency only in some subsample periods in selective markets. It is also reported that the uncovered interest-rate parity generally holds true and hence the forward bias puzzle is further reinforced as a statistical artefact. The differences in the institutional characteristics such as a country’s income level and the extent of foreign exchange market liberalization causes heterogeneous results in the state of foreign exchange market efficiency over subsample periods. This thesis has discovered some evidence indicating that the Asian financial crisis (AFC) of 1997/98 is the more disturbing event as compared to the global financial crisis (GFC) 2008/09 in terms of impact on foreign exchange market efficiency in the Asia-Pacific. We have shown that the currencies i managed under the free-float exchange rate regime as more resilient than those administered under the managed-float regime in the face of crisis. The empirical results have also confirmed that the exchange rates respond to both the United States and regional macroeconomic shocks. Finally, we have shown that those macroeconomic shocks related to the interest-rate announcements carry a larger impact to the exchange rates returns. Collectively, these findings bear several important implications for various stakeholders in the foreign exchange markets. It enables researchers to make a safe assumption of market efficiency in their future research work. For policymakers, they may want to take into account the resilience of free-float exchange regime in confronting a crisis when considering which regime to be adopted as the preferred currency management system. To market participants, they may have to be very cautious in applying a currency carry trade strategy, which aims to exploit the failure of the uncovered interest-rate parity, in the Asia-Pacific foreign exchange markets as the empirical results show that the parity condition generally holds true in the long run. ii ABSTRAK ( Malay Language Version ) Pasaran matawang asing adalah pasaran kewangan yang terbesar di dunia. Menurut laporan daripada Bank for International Settlement 2010 Triennial Central Bank Survey , nilai dagangan tahunan dalam pasaran matawang asing adalah dianggarkan berjumlah sekitar USD1,000 trilion. Rentetan itu, segelintir kacauan dalam effisiensi pasaran matawang asing akan memberikan peluang keuntungan yang cukup besar. Tesis ini meninjau effisiensi pasaran matawang asing dengan menggunakan matawang dari rantau Asia Pasifik. Daripada liputan literasi dalam kajian pasaran matawang asing, kami mendapati bahawa bukti empirikal berkaitan dengan effisiensi pasaran adalah bercampuran dan tidak muktamad. Tambahan pula, kajian dalam effisiensi pasaran matawang terutamanya dari rantau Asia Pasifik amatlah terabai. Kami menggunakan dua pendekatan utama yakni ‘ forward unbiasedness hypothesis’ dan ‘event-study analysi s’ dalam tesis ini. Dalam pengetahuan kami, ini adalah kajian pertama yang menggunakan kedua-dua pendekatan ini dalam satu kajian tunggal. Dengan cara ini, kami berupaya memberikan suatu gambaran yang lebih menyeluruh dalam effisiensi pasaran matawang asing. Secara keseluruhannya, kami mendapati bahawa pasaran matawang asing di rantau Asia Pasifik adalah effisien dalam tempoh masa sampel yang penuh tetapi menunjukkan cirri-ciri ineffisien dalam beberapa subsampel tempoh masa. Tesis ini juga menunjukkan bahawa ‘ uncovered interest-rate parity ’ adalah rata-ratanya benar dan justeru itu ‘ forward bias puzzle ’ merupakan suatu artifak statistik. Kami melaporkan bahawa perbezaan dari segi karektor institusi seperti aras pendapatan negara dan kadar liberalisasi pasaran matawang asing sesebuah negara adalah faktor penyebab dalam ketidaksamaan dalam keputusan yang diperoleh daripada ujian empirikal. Tesis ini juga menjumpai bukti yang mencadangkan bahawa krisis kewangan Asia 1997/98 sebagai peristiwa yang lebih mangacau berbanding dengan krisis kewangan global 2008/09 dari segi impak kepada effisiensi pasaran matawang iii asing di rantau Asia-Pasifik. Kami menunjukkan bahawa matawang yang dikendalikan di bawah rejim ‘free-float ’ adalah lebih berdaya-tahan berbanding dengan matawang yang diuruskan di bawah rejim ‘ managed-float ’ dalam mengharungi krisis. Hasil penyelidikan kami juga mengesahkan bahawa matawang asing sememangnya dipengaruhi oleh kejutan makroekonomi dari Amerika Syarikat and serantau. Akhirnya, kami mendapati bahawa kejutan makroekonomik yang berkaitan dengan pengumuman kadar faedah memberikan impak yang lebih besar kepada pulangan matawang asing. Secara kolektifnya, hasil kajian kami memberikan beberapa implikasi penting kepada pelbagai pihak yang berkepentingan dalam pasaran matawang asing. Kesimpulan tesis ini membolehkan para penyelidik untuk menggunakan andaian effisiensi pasaran matawang asing dalam kerja-kerja penyelidikan pada masa depan. Dari perspektif penggubal polisi, mereka boleh menggunakan hasil penyelidikan kami yang berkaitan dengan kelebihan rejim ‘ free-float’ dalam mengharungi krisis sekiranya mereka ingin mempertimbangkan rejim mana yang lebih bersesuaian. Peserta pasaran matawang asing pula harus berwas-was dalam menggunakan strategi ‘c arry-trade ’ yang mengeksploitasikan kegagalan ‘ uncovered interest-rate parity ’ pada matawang Asia Pasifik kerana hasil penyelidikan kami menunjukkan bahawa hubungan ‘ parity ’ ini adalah benar dalam jangka masa panjang. iv ACKNOWLEDGEMENTS In my opinion, this is one of the most important and meaningful sections in the whole thesis. This thesis will not come to fruition without the parties whom I am going to mention in this section shortly. First of all, my heartfelt gratitude goes to both of my supervisors, Associate Professor Dr. Rubi Ahmad and Professor Dr. Mohamed Ariff. Their dedication and encouragement have spurred me to stretch beyond my conservative boundary in order to achieve greater heights. I am also especially grateful to Professor Dr. Ghon Rhee, the Editor of Pacific Basin Finance Journal (PBFJ) from the University of Hawaii who visited my university twice as a visiting professor during my PhD program. His generous guidance has tremendously helped me to increase the quality of my thesis. Special thanks also go to the reviewers and Co-Editor of the Journal of International Money and Finance (JIMF) for their constructive suggestions and comments on parts of my work. The inputs from the participants of the Asian Finance Association Conference 2012, Malaysian Finance Association Conference 2012 and the European Financial Management Symposium 2011, especially the discussants of my works who include Dr. Zhang Wei from Deakin University (Australia), Professor Dr. Catherine Ho from the UiTM (Malaysia) and Professor Dr. Goh Soo Khoon from the USM (Malaysia), are also duly acknowledged. I would also like to thank my market intelligence providers, Mr Tang Vern Yang from the UOB Bank, Mr Tay Choon Siang from the Commerzbank and Ms Catherine Tan from the Thomson-Reuters. Last, but definitely not least, my deepest gratitude goes to my family members. Without the constant support from my beloved wife, Yee Sok Ling and my ever-giving mother, Chin Lai Hing, my PhD journey will never be so fulfilling and joyful. Thanks to my late father, Wong Kok Keong, for initiating me to embark on this route. I am also grateful to my sister, Wong Choy Yee, and her husband, my brother-in-law, Mr Yeoh Chia Hung, for bringing faith and happiness to our family. v TABLE OF CONTENTS i LIST OF FIGURES ................................................................................................. viii ii LIST OF TABLES .................................................................................................... ix iii LIST OF ABBREVIATIONS .................................................................................. xi 1 INTRODUCTION................................................................................................. 1-30 1.0 Underlying Financial Theories ............................................................................