International Parity Conditions

International linkages among markets for goods, capital and foreign exchange play a key role in the process of exchange rate determination. The nature of the equilibrium implied by these linkages and the speed with which this equilibrium is attained have important implications for the ability of governments to pursue independent domestic stabilisation policies. There is little dispute about the proposition that the more integrated the international markets the greater is the prospective difficulty in pursuing independent domestic monetary policies. For example, if financial (capital and foreign exchange) markets around the world are highly integrated, then perfectly mobile cross-border capital flows would force a convergence of the expected real rates of return on identical assets denominated in different currencies. Consequently, currency denomination would become largely irrelevant to borrowing and lending decisions. If this proposition is valid, then domestic monetary policy will have no effect on the expected real rate of interest faced by borrowers and lenders.

The purchasing power parity (PPP) hypothesis, which postulates a relationship between exchange rates and prices, is one of the most thoroughly examined topics in international finance and in economics at large. Yet it remains a highly controversial topic, both from the theoretical and empirical perspective.

The covered interest parity (CIP) hypothesis — which postulates an equilibrium relationship between the spot exchange rate, the forward exchange rate, domestic interest rates and foreign interest rates — was originally developed by Keynes (1923). In essence, it is the earliest theory of forward exchange, stipulating that the forward exchange rate tends to be equal to its interest parity rate (that is, the spot exchange rate adjusted by a factor reflecting the interest rate differential on domestic and foreign short-term financial assets). Put differently, the forward premium (discount) is postulated to be equal to the short-term interest differential. If the short-term interest rates on domestic and foreign assets with similar risk characteristics are not the same, then covered interest arbitrage will be profitable unless or until the forward premium (discount) is equal to the short-term interest rate differential (the actual forward rate is equal to its interest parity rate). Once equality is reached, any opportunity for arbitrage profit will be eliminated; consequently, the tendency for the movement of funds in either direction will disappear.

The uncovered interest parity (UIP) hypothesis postulates an equilibrium relationship between the market’s expected rate of change of the spot exchange rate and the interest rate differential on perfectly substitutable domestic and foreign assets. This hypothesis stipulates that if the interest rate differential is different from the expected rate of change of the exchange rate, risk neutral agents tend to move their uncovered funds across financial markets until equality is re-established. Under the joint assumption of risk neutrality and rational expectations, another hypothesis can be derived from the CIP and UIP conditions which postulates that the forward rate (the forward premium) is equal to the market’s expectation of the future spot exchange rate (the expected rate of change of the spot exchange rate), implying (unbiased) efficiency in the forward exchange market.

The real interest parity (RIP) hypothesis postulates that if the world markets for goods, capital and foreign exchange are integrated, real interest rates on perfectly comparable financial assets tend to be equalised across countries over time. This hypothesis predicts that the nominal interest rate differential adjusts fully to the inflation differential, maintaining the constancy and equality of real interest rates across countries. In essence, the hypothesis relies on the stability of the Fisher closed condition.

We have argued that the development of cointegration analysis has been a factor leading to the resurgence of interest in international parity conditions. It may, therefore, be appropriate to present an introduction to the cointegration literature, with particular emphasis on the techniques that have been used to test the hypotheses underlying these conditions. This chapter deals with the basics of cointegration analysis, while Chapters 7 and 8 deal with the techniques of testing for unit root and cointegration respectively.

The objective of this chapter is to present some of the most widely used tests of stationarity and unit root. These tests are widely used in the literature on international parity conditions as tests for the order of integration, mean reversion and cointegration.

A simple cointegrating regression (normally including a constant term) may be written as The cointegrating regression is sometimes referred to as the ‘equilibrium model’. However, equilibrium in this sense is different from what is implied by rational expectations models. It is arguable that the cointegrating regression does not necessarily imply a long-run relationship: economic theory must support such a relationship. Table 8.1 shows some cointegrating regressions that are frequently encountered in the literature on international parity conditions (lower-case letters imply natural logarithms). Some possible coefficient restrictions are also given.

In formulating PPP as a testable hypothesis a model needs to be specified. PPP models can be classified, according to the degree of restriction, into three types: the univariate model, the bivariate model and the multivariate model. The univariate model is arrived at by imposing the restrictions representing the properties of symmetry and proportionality to derive an expression for the real exchange rate. This model is given by Testing for PPP would, in this case, boil down to testing the behaviour of the real exchange rate, q _t . This specification implies that cointegration between the nominal exchange rate and relative prices is a necessary but not a sufficient condition for long-run PPP to hold, the sufficient condition being that there is one-to-one correspondence between the nominal exchange rate and relative prices. In this case, empirical testing is concerned with the property of mean reversion in the real exchange rate. In the jargon of cointegration analysis, this specification implies the imposition of the restriction of (1,−1,1) on the cointegrating vector. Hence it is the real exchange rate, not the residuals of the unrestricted cointegrating vector, that is tested for unit root.

The empirical validity of PPP has been tested for a large number of currencies under both fixed and flexible exchange rates. For this purpose researchers have employed a variety of estimation techniques, various model specifications and sample data with varying frequency and time horizons. Evidence on PPP can be classified under the following main headings: (i) evidence from the flexible exchange rates of the 1920s; (ii) evidence from post-Bretton Woods flexible exchange rates; (iii) evidence from the EMS and other European countries’ exchange rates; (iv) evidence from the exchange rates of other countries; (v) evidence from long-run data (ignoring changes in exchange rate regimes); and (vi) evidence on the ‘augmented’ PPP. Obviously, overlapping in this kind of classification is inevitable.

The objective of this chapter is to present an outline of the various procedures employed to test the covered interest parity hypothesis. This is followed by an overview of the empirical evidence related to some of the factors believed to contribute to deviations from the CIP condition.

Empirical work on UIP can be divided into three strands. The first is concerned with testing UIP in order to examine the extent of integration between financial markets (foreign exchange and capital markets) across countries. This is considered to be a direct test because the actual relationship representing UIP is tested by using data on both interest rates and spot exchange rates. The second strand pertains to testing UIP by examining linkages between nominal interest rates across countries. This may be considered as an indirect test because it relies on the maintained hypothesis that the expected rate of change of the spot exchange rate and the risk premium are stationary. The third strand focuses on testing UIP indirectly by using data on exchange rates only in order to find out whether or not unbiased efficiency holds. Testing unbiased efficiency can be viewed as an indirect test of UIP because it relies on the maintained hypothesis of CIP. In the following sections we present an overview of investigative work carried out in the three strands.

Studies involving inflation expectation mechanisms other than rational expectations are generally based on a regression equation normalising on the nominal interest rate. Moreover, most of these studies have focused on testing the constancy of the real interest rate within the United States. Gibson (1972) tested the validity of the FH for Treasury bills of varying maturities over two periods (1952–70 and 1959–70) using the Livingston survey data on price expectations and obtained results which lent support to the hypothesis that the real interest rate is not affected by price expectations and that the nominal interest rate fully adjusts to inflationary expectations.

The objective of this book has been to survey the theoretical and empirical work on the four international parity conditions: PPP, CIP, UIP and RIP. An understanding of the theory and empirical validity of these conditions is critical to our understanding of international linkages among the markets for goods, capital and foreign exchange as well as the determination of exchange rates and the movement of interest rates. The importance of these conditions is not only pertinent to the macro side of the economy, but also to the micro side. These conditions have significant implications for the investment, financing and hedging decisions of corporations operating in an international environment and having access to multi-currency sources of funds.