The free and unrestricted flow of capital in and out of countries and the everincreasingintegration of world capital markets can be attributed to the process ofGlobalization. The benefits of such integration are liquidity enhancement on one handand risk diversification on the other, both of which are instrumental in makingmarkets more efficient and also facilitate smooth transfers of funds between lendersand borrowers. India began a very gradual and selective opening of the domesticcapital markets to foreign residents, including non-resident Indians (NRIs), in theeighties.
The capital market opening picked up pace during the nineties. Real interest parity, uncoveredinterest parity and covered interest parity gives a indication of financial integration of economy. Three definitions of financial integration are as follows: (i) Real interest parity hypothesis states that international capital flows equalize real interest rates across countries. (ii) Uncovered interest parity states that capital flows equalize expected rates of return on countries’ bonds regardless of exposure to exchange risk. iii) Covered interest parity states that capital flows equalize interest rates across countries when contracted in the same currency. Only definition (iii) that the covered interest differential is zero is an unalloyed criterion for “capital mobility” in the sense of the degree of financial market integration across national boundaries. Condition (ii) that the uncovered interest differential is zero requires that (iii) hold and that there be zero exchange risk premium.
Condition (i) that the real interest differential be zero requires condition (ii) and in addition that expected real depreciation is zero. Literature Review The uncovered interest parity (UIP) theory states that differences betweeninterest rates across countries can be explained by expected changes in currencies. Empirically, the UIP theory is usually rejected assuming rational expectations, and explanations for this rejection include that expectations are irrational. There appears to be overwhelming empirical evidence against UIRP, at least at frequencies less than one year.
Other research shows that UIRP holds in long term. The results of these long horizon regressions are much more positive — the coefficients on interest differentials are of the correct sign, and most are closer to the predicted value of unity than to zero. Research done by Ravi Bansal and Magnus Dahlquistconclude that the often found negative correlation between the expected currency depreciation and interest rate differential is, contrary to popular belief, not a pervasive phenomenon. It is confined to developed economies, and here only to states where the U. S. nterest rate exceeds foreign interest rates. Research done for emerging markets by Frank S. Skinner shows that there isindeed violations in covered interest rate parity in the long-term capital markets andthe source of these violations is credit risk rather than the size of the economy orliquidity of the foreign exchange market. The covered interest parity (CIP) postulates that interest rates denominated in different currencies are equal once you cover yourself against foreign exchange risk. Unlike the UIP, there is empirical evidence supporting CIP hypothesis.
Empirical studies by various researchers shows that the CIP holds in most cases on the Eurocurrency market (where remunerated assets have similar default and political risk characteristics) since the collapse of the Bretton Woods regime in early 1970’s. In the Indian context, Varma (1997) has undertaken an analysis of the covered interest parity. He posits a structural break in the money market in India in September 1995, with CIP become effective from that point on for the first time in the Indian money market.
The structural break itself is attributed to interplay between the money market and the foreign exchange market. The period after 1995 is however witness to several deviations from the CIP. Varma has used rates on Treasury bills, certificates of deposit and commercial paper and call money rate to analyze the Indian money market. One problem encountered in examining covered interest rate parity is a lack of highquality observations on long-term interest rates the terms of which are comparableacross different markets. A ready solution is the interest rate swap market.