Effect of Interest Rates on Foreign Exchange Rates in Kenya: A Test of the Forward Premium Puzzle

Abstract

The main objective of this study was to examine the presence of the forward premium puzzle in the foreign exchange market in Kenya. The study used the Kshs/USD exchange rate for the period 1994 to 2016. That data consisted of monthly observations of the exchange rate, monthly observations of the 91-day Kenya government Treasury Bills Rate and the 91-day US government Treasury Bills rate. As a matter of procedure the data were tested for nonstationarity using the ADF test in level forms and in first differences. The result revealed that foreign exchange rates, interest rates and the risk premium are nonstationary. Furthermore, these variables were found to be cointegrated. Therefore, this study applied the VECM instead of the classical Granger causality tests to the data. The results show that the coefficient of the forward premium is not only negative but also statistically significant at the 5 percent level. This indicates the presence of the forward premium puzzle in the foreign exchange rate market in Kenya. Moreover, the forward premium contains information that can be used to improve the prediction the foreign exchange rate.