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The main advantage of measuring financial integration by means of testing interest rate parity conditions is that it is the cleanest method of all. It is exactly known what and which market segment is being measured so as to leave little room for misinterpretation. It is intuitively easy to understand and based on long-established economic laws of price competition among rational agents: if markets are open then the prices of similar goods (in this case financial instruments) between markets will be the same and if prices are not the same then barriers of some sort (e.g. capital controls) must exist. This is why this strand of theory is most widely preferred. Eijffinger and Lemmen (2003b, p xiv) for instance state that “the law-of-one-price definition of international financial integration is theoretically preferable, [but that] the measurement of international financial integration has often relied on broader concepts.” This strand has therefore drawn the most numerous empirical tests. But not all interest parity conditions have yielded equally good results

and positive support from its users. Frankel (1992, p 197) for instance claims that only the covered interest parity (CIP) condition is “an unalloyed criterion for capital mobility in the sense of the degree of financial market integration across national boundaries”. Referring to earlier studies he conducted in 1989 and 1991, he concludes on the basis of CIP calculations for a panel of 25 countries that barriers have been low in eight developed countries at least as far back as 1982. Based on estimates of a time trend in the absolute value of CIP differentials, ten countries have a rate of decrease in the magnitude of the barriers that is statistically significant at the 1% level. Frankel (1992) also discovers that calculations based on real interest (RIP) differentials for the same data panel yield different and sometimes anomalous results and offers the explanation that a substantial currency premium appears to drive real interest rates away from zero. The same evidence is brought in Frankel and MacArthur (1988) for a set of 24 countries, including seven less developed countries for the period 1982 to 1987. A high degree of capital mobility is found for most G11 countries and Hong Kong and Singapore when based on CIP but not to the same degree, if at all, when based on RIP. The differing results on the basis of CIP and RIP are not inconsistent: financial integration of markets can be achieved in the sense that a country premium is eliminated but where a currency premium remains.

It is important to note that these early studies of interest rate parity differentials use money market rates series which are often consistently available for a large number of countries. Therefore, these studies measure the integration of international money markets only and are silent on other financial market segments. Eijffinger and Lemmen (1995) also present an empirical analysis of money market integration in Europe between 1979 and 1992. From mean (absolute) deviations from CIP for ten countries vis-à-vis Germany based on 3-month domestic interest rates, they conclude that with regard to the degree of financial integration, the size and variability of country premiums decline significantly after 1987. The same calculations based on UIP, however, provide dissimilar results for certain countries (e.g. the UK) and the failure of PPP and thereby also RIP is evident for an even greater set of countries. As with Frankel’s studies, these results are neither inconsistent as UIP violation can be attributed to expectation errors or an exchange risk premium, which for RIP are compounded with the violation of ex post PPP.

Mussa and Goldstein (1993) generalize these results from interest parity conditions for short-term financial integration from a wider range of studies with four main observations. First, CIP holds to close approximation for most short-term money markets in industrialized countries. Secondly, CIP differentials decline during the 1980s signifying closer integration. Thirdly, UIP does not tend to hold and that assets denominated in different currencies are regarded as imperfect substitutes. Fourthly, RIP is even rarer as this also implicitly requires close integration of the goods markets. At best, studies based on UIP and RIP show in the presence of significant differences a declining trend in size and variability (e.g. Eijffinger and Lemmen, 1995). In periods of substantial exchange rate volatility, real interest differentials are more

accounted for by currency premiums than by country premiums (e.g. Frankel and MacArthur, 1988;

Frankel, 1992).

Whereas this strand of theory starts off with the financial integration of money markets, subsequent efforts extend the scope of integration to include different asset classes. Three studies in particular are notable. The first one is from Popper (1993), who extends the interest parity strand to the longer end of the fixed income markets. Using currency swaps for five developed countries versus the US for the period 1985 to 1988, Popper is able to establish that mean absolute CIP deviations are not too dissimilar for five and seven year government bond maturities compared to 3-month money market maturities. She concludes that short-term integration extends with the wider use of swaps to long term integration in the late 1980s. Another within the realm of fixed income markets is from Montiel (1994), who extends it to the domain of less developed countries. Estimating mean absolute deviations from UIP for 6-month deposit rates of 48 such countries versus 6-month US Treasury bills, Montiel finds that results are very mixed but that at least six countries can be identified as having high capital mobility. Dividing the sample period in half reveals that capital mobility increases in eleven countries. Both these studies highlight the inherent problem of interest parity studies of finding comparable assets when venturing into the longer or the higher yielding end of fixed income markets where assets are less substitutable. Finally, Mussa and Goldstein (1993) report that yet another branch extends the scope of integration enquiries to equity markets, where one approach is to examine premiums observed in closed-end country mutual funds but the more common approach is to consider correlations of stock price indexes and returns across countries.

Results thus far are mixed, with these first studies showing that a number of country funds have significantly decreased premiums over the 1981 – 1989 period but the second studies showing that correlations of stock market movements across industrial countries are moderate in size and had not increased in the previous twenty years or so. This could again be an indication that in the equity markets, stocks in different currencies are regarded as imperfect substitutes. Overall, devations on interest parity studies that venture beyond the money markets remain somewhat of a rarity in the literature.

Notwithstanding the attractiveness of using interest parity conditions to measure the degree and the process of international financial integration, which they are clearly very capable of doing, particularly for short-term fixed income markets, this review also reveals a number of implicit shortcomings of this strand. These shortcomings can be summarized as follows. First, while CIP is the condition that holds most often, the risk with interest parity conditions based on CIP is that one possibly presents a tautology. From the practices of market participants it is evident that CIP is closely monitored at all times, because traders in the foreign exchange and currency swap market continuously use interest rate differentials to set the price of forward rates and vice versa. Secondly, evidence is strictly limited to the integration of specific segments of the financial markets only, mostly money markets. These are also markets that tend to be the

most liquid and widely traded by large, sophisticated financial institutions. If, as suggested by Von Furstenberg (1998) international financial integration should also contribute to economic welfare by succeeding in integrating the market for a large number of diverse financial services, then interest parity conditions applied in this sense are of limited value. Thirdly, interest parity studies are prone to

measurement error as the quality and reliability of measuring financial market integration with parity conditions depends heavily on the comparability and substitutability of assets. Differences in default risk, term to maturity and liquidity reduce substitutability and can lead to measurement error. To circumvent other sources of measurement error, it is important that the timing of interest rate data corresponds with the timing of exchange rate and other data necessary for the calculations. Fourthly, interest rate parity studies based on UIP and RIP are a joint test of financial integration and rational expectations, where their failure can be attributed to either or both. If realized exchange rate changes are a bad proxy for future exchange rate changes then UIP will not hold, and the same for expected price changes in the case of RIP.