Conventional wisdom suggests flexible exchange rate regimes effectively absorb external shocks due to monetary policy autonomy. However, recent evidence challenges this notion, highlighting that external shocks can exacerbate conflicts between economic activity and price stability. This vulnerability extends to market efficiency, questioning whether foreign exchange markets accurately reflect currency values during volatility. Fama's Efficient Market Hypothesis (EMH) posits that prices reflect all relevant information, implying efficient price adjustments. However, studies show long-memory in exchange rate volatility, suggesting inefficiency. The impact of external shocks, including those from events like the 2008 financial crisis and the Russia-Ukraine war, is multifaceted, affecting macroeconomic indicators such as exchange rates, expectations, money supply, asset prices, and interest rates. Many studies focus on macroeconomic aspects, neglecting the micro-market effects on volatility persistence and market efficiency. Malawi's experience with various exchange rate regimes, including a managed float, provides a valuable case study to examine the impact of external shocks on its foreign exchange market. The country's economic performance is influenced by weak resource endowments, production volatility, international economic developments, and domestic policies. This paper examines the impact of external shocks on the volatility of the Malawian Kwacha against the US dollar, and evaluates market efficiency, adding to the literature by focusing on micro-transmission effects of multiple shocks and incorporating recent macroeconomic events.

The literature on exchange rate regimes and their ability to absorb external shocks is divided. The Mundell-Fleming model suggests that monetary autonomy in a flexible exchange rate regime can counter external shocks, but studies like Corsetti et al. (2021) show that this insulation can be limited. Other research highlights the vulnerability of small open economies to external shocks, especially during financial crises. The leverage effect hypothesis and volatility feedback hypothesis explain the asymmetrical impact of shocks on financial markets. The leverage effect suggests that price declines increase volatility, while the volatility feedback hypothesis posits that volatility affects asset prices. While studies examine the effects of individual external shocks like epidemics on volatility, there is a lack of research on the combined impact of multiple shocks. This study considers this gap, focusing on the asymmetrical impact of external shocks on a small open economy's foreign exchange volatility. Prior research on Malawi's exchange rate volatility has examined the RBM's actions and the impact of volatility on specific exports, but lacks an analysis from the perspective of external shocks and market efficiency. The Efficient Market Hypothesis (EMH) and the Fractal Market Hypothesis (FMH), which extends EMH to nonlinear markets, provide theoretical frameworks for analyzing market efficiency. Studies have examined market efficiency during past crises, but more recent events like the Covid-19 pandemic and the Russia-Ukraine war warrant further investigation.

This study uses daily MK/USD exchange rate data from the Reserve Bank of Malawi, covering June 2011 to June 2022. Pre-analysis includes tests for structural breaks (Bai-Perron test) and heteroscedasticity (ARCH LM test). The analysis is divided into two parts: the impact of external shocks on volatility persistence and the relationship between external shocks and market efficiency. Three rolling windows are defined based on structural breaks. GARCH-type models (GARCH, E-GARCH, and T-GARCH) are used to analyze volatility persistence, accounting for non-linearity and asymmetry. The models include control variables (inflation, balance of payments, and foreign exchange reserves) to account for domestic factors. Volatility persistence is assessed by the sum of ARCH and GARCH coefficients. Asymmetry is assessed by comparing the impact of positive and negative shocks. The study uses OLS regression to assess the impact of external shocks on return predictability, including calendar effects as control variables. The Forward Rate Unbiasedness Hypothesis (FRUH) is used as a robustness check to examine market efficiency. The study tests for the 1:1 relationship between spot and forward exchange rates, with deviations indicating market inefficiency. Domestic influences are incorporated via a stepwise relaxation of models.

Descriptive statistics reveal significant variations in the data, particularly in control variables. The return series shows positive skewness and leptokurtosis. The cusum plot suggests structural breaks in the return series. The Bai-Perron test reveals one structural break in the return series (2014m3-2017m10) and two in the volatility series (2015m2 and 2015m8-2016m6), coinciding with the Russia-Ukraine war. The ARCH LM test confirms ARCH effects. The Ljung-Box test shows autocorrelation in the return series, resolved by using first differences. GARCH models show significant long memory in volatility, with external shocks having a larger impact during negative shocks than positive shocks. The E-GARCH model confirms asymmetry, with negative shocks having a stronger effect on volatility. The T-GARCH model reveals the more pronounced impact of negative shocks (bad news). Relaxing the models to include domestic factors shows that while domestic factors influence volatility, the effect of the first structural break (Russia-Ukraine war) remains statistically significant, particularly during negative external shocks. The OLS regression analysis on market efficiency shows that the occurrence of external shocks significantly increases the predictability of returns, contradicting weak-form efficiency. The FRUH tests confirm market inefficiency, showing significant deviations from the 1:1 relationship between spot and forward rates in all windows.

The findings support the volatility feedback effect over the leverage effect, showing that external shocks lead to volatility, resulting in currency depreciations. The long-memory effects in volatility reduce the effectiveness of monetary interventions. The study augments the macroeconomic transmission mechanism by incorporating micro-transmission channels. The results highlight the limitations of monetary autonomy in a flexible exchange rate regime and challenge Dornbusch's overshooting model in the context of Malawi. Domestic factors also play a significant role, emphasizing the need for macro-prudential policies alongside monetary interventions. The study's micro-level focus provides valuable insights for policymakers, investors, and information managers.

This study demonstrates the significant and persistent impact of external shocks on Malawi's foreign exchange market volatility and efficiency. The long-memory nature of volatility underscores the limitations of monetary interventions. The asymmetrical impact of negative shocks and the failure of the FRUH to hold highlight market inefficiencies. Policy recommendations include strengthening forex reserves and implementing robust fiscal policies to mitigate vulnerabilities. Future research could explore the role of specific macroeconomic indicators or other external shocks.

The study uses data up to June 2022. Including more recent data would provide a more comprehensive picture. The focus on the MK/USD exchange rate limits the generalizability of the findings to other currency pairs. The study relies on a specific set of macroeconomic control variables, which could be extended.