Test efficiency in the FOREX market using FRU and UIP : VAR methodology

Abstract

Huge economic collapse resulted from the crisis in 1997, during which the Thai government authority had to let the baht float freely. This was caused by the imparity of the domestic and foreign exchange rates, interest rates and forward rates before the crisis. After the government authority changed the exchange rate system to a floating exchange rate system, there is still a question of whether the new government policies and new circumstances eliminated the imparity. The study is to test the efficiency of the Thai FOREX market before and after the switching the foreign exchange rate regime using the VAR methodology both theories of Forward Rate Unbiasedness (FRU) and Uncovered Interest Parity (UIP) are tested in three different models for single and multiple periods. The result showed that in the case of one-period test by using OLS the null hypotheses of FRU and UIP were rejected in both fixed and floating system. The result from OLS might not clear enough because in the ULS model it did not include the feedback effect of those variables. The methodology that includes feedback effect in the model is VAR. The two-period tests of both a two-variable and a three variable VAR model showed that during the period of fixed system both the null hypotheses of FRU and UIP were rejected, but during the floating system both null hypotheses were accepted. This indicates the market was inefficient during the fixed exchange rate system but more eficient during the period of floating system.