A Study On The Effectiveness Of China's Foreign Exchange Market

There has been more than 3 years from the exchange rate reform of July 2005. China's exchange rate regime has been changed from pegging to the U.S. dollar to an exchange rate which is based on supply and demand in the market with reference to a basket of currencies. This is a floating exchange rate system which is managed. The formation of the RMB exchange rate mechanism has become more flexible. China's foreign exchange market has undergone enormous changes since more than 3 years ago. The increasing number of participants- many financial institutions, businesses and residents are actively involved in the foreign exchange transactions. The transactions are becoming increasingly active and the scale of the transaction is also expanding. However, there are also a lot of questions about the Chinese foreign exchange market in the process of development. Such as the less developed foreign exchange derivatives market, the Central Bank's over intervention and so on. It will be a long way to go to the sophisticated foreign exchange market. After the exchange rate reform, whether China's foreign exchange market is efficient and whether the changes in the RMB exchange rate reflect the real changes of the supply and demand in the market remain are unknown. Therefore, it is necessary to test the effectiveness of China's current foreign exchange market.This article includes the introduction and the four chapters of the main content.In the introduction, the background and significance of the issues discussed in the article firstly. And then we sort out the results of former researches and analysis and on the issue systematically. And then the organization and the structure of this article are illustrated. And at last the innovation and the shortage of the article are pointed out.The first chapter which is the theoretical basis of this article includes three parts: the first part outlines the proposed course of the Efficient Market Hypothesis. Among all scholars, Fama is most famous. He pointed out the relationship of the prices and information (including historical information, public information, internal information). The second part introduces three major types of the market: weak-form efficient market, semi-strong efficient market, strong efficient market, as well as the two assumptions of the effectiveness of the foreign exchange market: the first one is that speculators are risk neutral and the other one is that market investors are rational expectations. At last, in the third part, the development as well as the criticism of the theory has been revealed. We mainly introduce the three challenges of the theory which were pointed out by the scholars when they did empirical studies .And then we explain why people failed when they test the effectiveness of foreign exchange market. There are several reasons: rational speculative bubbles, the peso problem, the subsidies of the risk, "news" model.Chapter II of the thesis summed up all the development stages of the China's foreign exchange market. The development history of the Chinese foreign exchange market is divided into three phases: phase of foreign exchange swap markets, phase of foreign exchange swap open market, phase of standardization and market-oriented interbank foreign exchange market, phase of further toward market-oriented foreign exchange market. I introduce the characteristics of each stage separately as well as progress and development than before. Throughout the second chapter, we can see that China's foreign exchange market continues to improve, step-by-step towards maturity, and became close to the weak efficient market.Chapter III is the core of this paper which is mainly about empirical analysis. There are five parts. The first part is the traditional method of testing the effectiveness of the foreign exchange market in which I briefly introduce the filter test. While, I focus on the random walk model and describe the two unit root tests - ADF test and PP test. I also give measurement models respectively. The second part is the introduction of the martingale difference test as well as the concepts of "fair game", "martingale difference ". And we come to a conclusion that the weak validity of the exchange rate market can be tested by test whether the logarithm returns of the exchange rate are martingale difference sequence or not. Finally, we give necessary and sufficient condition for the establishment of the martingale as well as its proven processes. The third part illustrate the model data: This paper selects for date exchange rate of the RMB against the U.S. dollar, the euro, the Hong Kong dollar and the Japanese yen's data as a sample. The sample interval is from July 25, 2005 to February 16, 2009. And then we map out the various exchange rate trends by using the measurement software as well as give some brief descriptions and analysis. The fourth part is about empirical analysis and the test results. First of all, we apply for the traditional unit root test, calculating the test results by using the software to educe the result of ADF test and PP test. These test results show that the Chinese foreign exchange markets are weak-form efficient market. But this conclusion is not reliable, because the unit root hypothesis is a necessary but not sufficient condition for the random walk process. Besides, the effective market is not implicit with random walk and meanwhile the random walk does not necessarily implied by the market effectively. Then, I make use of the research results of Kuan and Lee (2004) - martingale difference test. I use their test statistic- J g?D?→X2, and then give the corresponding hypothesis: null hypothesis: if H 0 : Yt = log( X t ) ? log( X t?1) is the martingale difference sequence, the market is a weak-form efficient market. Alternative hypothesis: if H 1 : Yt = log( X t ) ? log( X t?1) is not a martingale difference sequence, the market is not the weak-form efficient market. Then I use the EXCEL, EVIEWS statistical software to calculate the exchange rates which lag three periods. And therefore, the martingale difference sequences of the rate of return of RMB against the U.S., RMB against the euro, the RMB against the Hong Kong dollar, RMB against the yen are calculated. Part V is a analysis of martingale-difference test results. The test results refuse that the rate of return of RMB against the U.S. dollar and the Hong Kong dollar are martingale difference sequences. This indicates that both the foreign exchange markets are null and void. The test statistics of RMB against the euro and the yen are smaller than the threshold. So we should not refuse that the two are martingale difference sequences. These two markets are weak efficient markets. However, through further analysis we found that the second conclusion is questionable. At the same time, analysis shows that the foreign exchange market of RMB against the Hong Kong dollar is not an effective market.Chapter IV describes the policy proposals for improving the foreign exchange market. It includes two parts: the first part is an overview of the questions existing in the current Chinese foreign exchange market. I analysis them from two aspects-the problems in the foreign exchange transactions market and the problems in the foreign exchange derivatives market. The problems are: the market coverage is small, the dealer's freedom of choice is restricted because of the trading methods, the continuity of the transaction can not be guaranteed, the central bank's interventions are too many, the types of foreign exchange derivatives are also not enough, the participants in the derivatives market are less, the pricing central regions which are representative and authoritative have not been formed and so on. According to the problem mentioned in the first part, the second part raises a number of policy recommendations, including: to perfect the system of laws and regulations, set up a formation of the foreign exchange market structure which is in favor of market-oriented exchange rate, to explore new transaction subjects and increase the number of transactions, to relax the inventory control of foreign exchange progressively, to increase the competition among foreign exchange banks, to develop the derivatives market and to perfect the intervention mechanism that the Central Bank do in the foreign exchange market.