Efficiency of Tanzania's foreign exchange market

Abstract

AbstractThis paper examines market efficiency in the foreign exchange market in Tanzania. A nonlinear Markov switching model was used to analyse the Tanzanian shilling against the US dollar spanning from 2 January 2009 to 30 April 2020. The estimation period was 2 January 2009–28 May 2019, and the post‐sample forecast period was 28 May 2019–30 April 2020. From the results of the two‐state Markov switching model, we define State 1, which is more volatile, as the inefficient state and State 2, which is less volatile, as the efficient one. In the unconditional probabilities from the Markov switching model, the exchange rate has a 94% probability in the inefficient state, which indicates that 94% of all speculators fully extract information when predicting future exchange rates, while 30% of all investors do not; suggesting that the foreign exchange market undergoes conditions of efficiency and inefficiency. In addition, findings showed that the exchange rate is expected to spend approximately 18 days in regime 1 and 8 days in regime 2. The policy implication of these findings is that foreign exchange market participants should pay attention to regimes and underlying market conditions when designing and applying their investment strategies.