Testing the Random Walk Hypothesis for Real Exchange Rates

Testing the Random Walk Hypothesis for Real Exchange Rates

Rui Teixeira Dias, Pedro Pardal, Hortense Santos, Cristina Vasco
DOI: 10.4018/978-1-7998-6926-9.ch017
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This chapter aims to analyze the efficiency, in its weak form, in the exchange rates of Brazil vs. USA, Australia, Canada, Europe (Euro Zone), Switzerland, United Kingdom, and Japan from July 1, 2019 to September 20, 2020. The results suggest that exchange rates show signs of (in)efficiency, in their weak form (i.e., the values of the variance ratios are lower than the unit), which implies that returns are autocorrelated over time, and there is reversal to the average. In corroboration, the results of detrended fluctuation analysis (DFA) show persistence in yields (i.e., the existence of long memories), thus validating the results of the Lo and Mackinlay model that show autocorrelation between the series of yields. As a conclusion, the authors show that the assumption of market efficiency may be questioned, since the forecast of market movement may be improved if the lagged movements of the other markets are taken into account, allowing the occurrence of arbitrage operations in these foreign exchange markets.
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Coronavirus Covid-19 is a type of outbreak that first appeared in December 2019 in Wuhan City, Hubei Province, China. It was declared a pandemic by the World Health Organization (WHO) on March 12, 2020. According to the WHO, since the beginning of the pandemic the number of Covid-19 infected persons has already surpassed 55.6 million (confirmed cases) and 1.3 million deaths worldwide in November 2020 (AlAli, 2020; Liu, Manzoor, Wang, Zhang, and Manzoor, 2020).

The easy spread of this virus has caused uncertainty in the global population. This epidemic has also changed people's lifestyles; it has caused job losses and threatened the livelihoods of millions of people as companies closed to control the spread of the virus. Globally, the rapid spread of Covid-19 has had devastating impacts on the global economy, and consequently on financial markets around the world (Zhang, Hu, and Ji, 2020; Ali, Alam, and Rizvi, 2020).

International financial markets have seen a succession of major setbacks in recent months triggered by Covid-19, followed by a series of collapses, the oil war, and currency fluctuations. Associated with the coronavirus pandemic in 2019-2020, financial markets,, particularly stock, bond, foreign exchange and commodities markets have been characterized by high levels of turbulence (Abu Bakar, 2020; Liu, Manzoor, Wang, Zhang, and Manzoor, 2020; Njindan Iyke, 2020).

For instance, the oil price war has been a major cause of crashes in international financial markets in 2020. In the first weeks of March, oil prices in the United States fell 34%, crude oil fell 26% and Brent oil fell 24%. These events were triggered by a disruption in the dialogue between the Organization of the Petroleum Exporting Countries (OPEC) and Russia on the proposed cuts in oil production due to the Covid-19 pandemic, with Russia with going the agreement, leading to the fall of the OPEC alliance. The price of oil had already fallen 30% since the beginning of that year due to the drop in demand. Saudi Arabia began a price war with Russia, leading to a quarterly drop of 65% in the price of crude oil. (Sharif, Aloui, and Yarovaya, 2020; Villarreal-Samaniego, 2020; Sudha, Sornaganesh and Sathish, 2020).

A market is informationally efficient when all relevant information is reflected in the price system. The lack of consensus among economists and financial analysts regarding market efficiency requires the study of the efficient market hypothesis (EMH). Another significant reason to study market efficiency is the role of financial markets acting as intermediaries between savers and borrowers in the distribution of scarce resources via the price mechanism (Jain, 2020; Karasiński, 2020).

According to Huang and Zhang (2019) the wealth that an entity has is usually composed of several assets denominated in different currencies, the value of which depends on the fluctuation of exchange rates. The analysis of the dynamics associated with exchange rates is one of the important concerns for market strategists, risk managers, particularly the impact of currency shocks on the real value of assets.

Informed speculation contributes to the price discovery process and efforts to reduce this speculation significantly reduces the informational efficiency in foreign exchange markets. This research intends to test the efficiency, in its weak form, of the exchange rates of Brazil vs USA, Australia, Canada, Europe (Eurozone), Switzerland, UK and Japan, namely the pairs BRL/USD, BRL/AUD, BRL/CAD, BRL/EUR, BRL/CHF, BRL/GBP, BRL/JPY, in the period from July 1, 2019 to September 20, 2020. To perform this analysis, different approaches were undertaken to assess the impact of the global pandemic on the efficiency of Brazil's foreign exchange markets. The results suggest that the global pandemic had harmful effects on the memory properties of Brazil’s exchange rates, i.e., random walk hypotheses are rejected in all markets. These findings show the existence of accentuated arbitrage levels, but the object of this study was not to analyze anomalous profitability without incurring additional risk.

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