International capital market integration

International macro, miniterm III, January 2007

Increasing capital mobility

• Breakdown of the Bretton-Woods system of exchange rates in 1972

• Fast growth of Eurocurrency markets

• Technological advances in information reduced arbitrage opportunities

• General trend for deregulations of markets

• European monetary union and introduction of Euro

Measuring degree of capital mobility: Saving-investment correlations

• Feldstein and Horioka, “Domestic Saving and International Capital Flows,” Economic Journal 90, June 1980, 314-29.– If capital was highly mobile across countries then corr (S,I) were close

to zero• Closed economy S=I, corr (S,I)=1• Small open economy, perfect capital mobility CA=S-I, r is exogenous,

savings and investments are affected by independent factors, corr (S,I)=0

Measuring degree of capital mobility: saving-investment correlations

Measuring degree of capital mobility: saving-investment correlations

• Positive relationship between saving and investment rates are also observed within countries over time. For OECD countries, for 1974-1990 it was equal to 0.495

• corr (S,I) was weakening over time reflecting increasing capital mobility. Frankel (1993) has shown that for US:– corr (S,I)=0.86 for 1929-1979– corr (S,I)=0.03 for 1981-1987

US saving and investment rates: evidence of increased capital mobility over time

Feldstein-Horioka puzzle and capital mobility

• Even under the perfect capital mobility, saving and investment rates can move together: increase in productivity can have a positive impact on both, S and I

• Large open economy effect: factors that have a positive impact on savings will also reduce world interest rate r*

Measuring capital mobility: interest rate differentials

• Under assumption of perfect capital mobility, the rate of return on financial investment should be equalized across countries

• Cross-country interest rate differentials would indicate restrictions on international capital flows

Uncovered interest rate parity

• Suppose that an investor has $1– i is US interest rate– i* is German interest rate– S is spot exchange rate in $US per Euro– S’ is spot exchange rate at the end of investment period

• To prevent arbitrage it should be the case that:

• However, S’ is not known at the beginning of investment period. But…

SSii /'*)1(1

Covered interest rate parity• …investor can secure certain exchange rate, F $US dollars per 1

Euro using forward exchange rate market!• Therefore, the following equality should hold if capital is perfectly

mobile:

0*

*

**)1ln(,)1ln(,ln,ln

*)1(1

fdii

then

sffd

Denote

sfii

then

iiiisSfFS

Fii

Example, as of January 29th, 2007

• US 3 month interest rate is i=5.24%• Euro 3 month interest rate is i*=3.76%• Spot exchange rate is S=1.291 $US per Euro• 3 months forward rate is F=1.297 $US per Euro• You should invest in Euro because

0141.10131.1

:later months 3 And291.1

297.1*)

4

0376.01(

4

0524.01

and

Arbitrage

• Borrow $1bln• Exchange in Euro at spot rate: 774.6 mln Euro• Invest in Euro assets• Buy $1.0131 bln at the forward market (no

payments at this point!)• In 3 months, your investment yields 781.87 mln

Euro• Execute forward contract: purchase $1.0131 bln

for 781.11 mln Euro• Your profit is 760,000 Euro• No risk involved, no initial capital is needed!!!

Alternative approach: differentials between domestic deposit rates and Eurocurrency deposit rates. For example, it compares interest rates on French franc deposits in France with interest rates on French franc deposits in London

Real interest rate differentials and capital market integration

• In the model of small open economy the real interest rate, r, is exogenously determined by the world real interest rate, r*.

• Testing r=r*

Real interest rate differentials

• Real interest rate differentials are not a good indicators of capital mobility!

• The difference in real interest rates across countries is equal to zero only if:– Relative price of consumption baskets across

countries does not change over time– People are risk neutral or there is no nominal

exchange rate uncertainty

Decomposition of the real exchange rate

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There are three terms on the right hand side:

i The degree of capital mobilityii Nominal exchange rate riskiii Expected changes in relative prices across countries

Decomposition of the real interest rate differentials

Exchange risk premium, f-se

• Measures the percentage difference between the forward and the expected future spot exchange rates

• If there is no uncertainty: Se=F• If agents are risk neutral and Se>F:

– Buy euros in the forward market is profitable– The forward exchange rate F is going up– Until Se=F

• Since exchange risk premium is not zero, there is uncertainty or people are not risk neutral or both

Expected real depreciation, se-s+π*e- πe

• Real exchange rate e is defined as: e=(S*P*)/P

• When e increases (real depreciation of domestic currency), foreign consumption becomes more expensive relative to domestic consumption.

• Decline in e is called real appreciation of domestic currency

Expected real depreciation

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sse

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ppse

ppse

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ason depreciati real expectedin changes expresscan We

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ln

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Back to real interest rate differentials

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0

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%

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fdii country premium is positive

exchange risk premium is positive

real exchange rate is expected to depreciate