Random walks in the U.K. pound/ U.S. dollar exchange rates

• Published in: International review of financial analysis 1998, Vol.7 (1), p.65-82
• Main Authors: Smoluk, Herbert J., Vasconcellos, Geraldo M., Kramer, Jonathan K.
• Format: Article
• Language: English
• Subjects: Foreign Exchange rates; Market efficiency; Variance ratios
• ISSN: 1057-5219; 1873-8079
• DOI: 10.1016/S1057-5219(99)80039-8

Since the adoption of flexible exchange rates in the early 1970s, tests of foreign exchange rate efficiency have abounded and can be categorized into three main approaches. The first approach is to examine exchange rates in an arbitrage context to determine if they are out of parity with interest rates or other exchange rates. The second approach to efficiency testing concerns the ability of forward exchange rates to predict corresponding future spot rates. The third approach to exchange rate efficiency testing is to examine exchange rates as a time series to determine whether or not they follow a random walk. This paper follows the third approach to exchange rate efficiency testing. Efficiency testing of exchange rates under the null hypothesis of the random walk is a natural progression in the research of exchange rate determination. This paper shows that the random walk hypothesis is not rejected for the £/$ annual real exchange rate. Although the £/$ annual real exchange rate has mean reverting tendencies due to PPP, frequent and strong shocks to the nominal exchange rate assure that the series follows a random walk since these shocks directly influence real exchange rates. The random walk hypothesis is also not rejected for the £/$ monthly nominal exchange rate, making profitable trading schemes between the currencies unlikely. Both conclusions are consistent in that a random walk in nominal exchange rates should lead to a random walk in real exchange rates.