Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Emerging Market Liberalization and the Impact on Uncovered Interest Rate Parity

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Emerging Market Liberalization and the Impact on Uncovered Interest Rate Parity

Article excerpt

Abstract: In this paper we make use of the uncovered interest rate parity (UIRP) relationship to examine the extent that the liberalization of emerging financial markets has resulted in the integration of developing countries' currency markets into the international capital market. Previous tests of the impact of liberalization on the integration of emerging markets capital markets into world financial markets are confined to equity markets, ignoring currency markets that arguably are more important in determining the success of financial liberalization. We find that, in general, deviation from UIRP in the emerging markets is systematic in nature and that a significant part of emerging market currency excess returns is attributable to time-varying risk premium. Importantly we also find that these countries' currency deposits provide U.S. (equity) investors the benefits of international diversification. Our results also show that for some markets, liberalization improved (worsened) investors' perception of growth opportunity while reducing (increasing) investors' perception of the probability of financial distress. Finally, while several countries benefited world capital market, the experience is country specific.

JEL classification: F21, F31, F36

Key words: capital market integration, uncovered interest rate parity (UIRP), financial liberalization, GARCH model

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A large number of studies has examined the impact of liberalization on the integration of emerging markets (see, e.g., Bekaert (1995), Bekaert and Harvey (1995), Korajczyk (1996), and Hunter (2002)). Although providing important insights regarding the success or lack thereof of the integration policies of these countries, these studies have in general focused only on integration of equity markets, neglecting other financial markets. This focus on equity markets suggests that researchers are implicitly making the assumption that integration of equity markets implies integration of other financial markets. It is usual for researchers simply to assume that currency markets are integrated. For instance, both Dumas and Solnik (1995) and De Santis and Gerard (1998) assume that currency and equity markets are internationally integrated and impose the same price of world equity market risk on portfolios of equities and foreign currency deposits.

A fundamental relationship in international finance is interest rate parity. It states that when the domestic interest rate is less than the foreign interest rate the domestic currency is expected to appreciate by an amount approximately equal to the interest rate differential. An implication of this known as the uncovered interest rate parity (UIRP), is that the return on an uncovered foreign currency deposit should be equal to the return on an equivalent domestic deposit regardless of the national market within which the foreign deposit is located. A violation of this relationship indicates that capital markets are not integrated (see, e.g., Frankel (1992,1993) and Montiel (1993)).

In this paper we investigate if the liberalization of emerging markets has led to the integration of their currency markets into the world capital market. We take the perspective of a U.S. investor and examine the extent to which the liberalization of emerging financial markets impacted the deviation from UIRP. Many studies of UIRP (these focus primarily on the developed markets) find that, in general, UIRP does not hold (see Engel (1996) for a survey). One of the more prominent explanations for this failure is the existence of a time-varying risk premium as a compensation for the speculative position in the foreign currency. (1) We argue below that, if deviation from UIRP is due to a risk premium, then a fortiori these deviations will exist in the emerging markets in the pre-liberalization period. On the other hand, if financial market liberalization has been successful in integrating developing countries' currency markets into the international capital market, then in the post-liberalization period U. …

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