Download Chapter 6:

CHAPTER 6
A Single World Marketplace —
International Financial Market Integration
CHAPTER OVERVIEW
Chapter 6 looks at the growing globalization of international financial markets and describes several popular
tests that have been used to measure the degree of international integration of these markets. The chapter begins
with a description of international capital and money markets, including recent developments in the euroinstruments such as Eurobonds and Euronotes, and Eurocommercial paper. The term “vehicle currency” is used
to describe a currency such as the dollar, which is most often used to conduct international transactions.
The next section describes empirical tests that have typically been performed for covered interest parity,
uncovered interest parity, ad foreign exchange market efficiency. Other tests that are discussed include those for
the Fisher equation relating real and nominal interest rates, as well as the real interest parity condition, which is
motivated by combining the Fisher equation and uncovered interest parity with exchange rate purchasing power
parity. The text points out that although deviations from real interest parity do exist, they tend to be relatively
small on average for most industrialized countries. Finally, the chapter describes the classic Feldstein-Horioka
study of capital market integration based on correlations between national savings and investment rates.
OUTLINE
I.
International Capital Markets
A. Size and Growth of International Capital Markets
B. Institutional Investors
C. Portfolio Diversification
II. International Money Markets
A. Maturities Less Than One Year
B. Foreign Currency Dominated Deposits Among Banks
III. Eurocurrencies, Euronotes, Eurobonds, and Eurocommercial Paper
A. Deposits and Loans Denominated in Non-Domiciled Currency
B. Increased Flexibility for Raising Funds
IV. Vehicle Currencies
A. Dominant Currency
B. Trends in Vehicle Currencies
54
Chapter Six
55
V. Capital Market Integration
A. Covered Interest Parity (CIP)
B. Uncovered Interest Parity (UIP)
C. Real Interest Parity
1. Fisher Equation
2. PPP and UIP
3. As Measure of Capital Market Integration
D. Saving and Investment
VI. Summary
FUNDAMENTAL ISSUES
1.
What are international capital markets?
2.
What are international money markets?
3.
What are the Eurobond, Euronote, and Eurocommercial paper markets?
4.
What are vehicle currencies?
5.
What is capital market integration?
CHAPTER FEATURES
1.
Policy Notebook: “Is Capital Market Liberalization the Right Policy?”
This policy notebook discusses the role of capital market liberalization in developing and emerging economies.
It notes the benefits of capital inflows, and the potential destabilizing force of capital flight. Different
governments have consequently responded to these benefits and costs in various manners: ranging from
liberalizing capital flows to implementing capital controls.
For Critical Analysis: The government of a developing or emerging economy would hope to attract long term
foreign capital that would reinforce sound macroeconomic fundamentals that these countries hope to continue to
establish and extend. These countries are typically hoping to attract foreign direct investment (FDI) to help
serve these goals. Similarly, portfolio investment plays a role in helping financial sectors to develop which will
aid in future financial intermediation.
2.
Policy Notebook: “The Failure of Interest Rate Convergence”
This notebook examines interest rate differentials as a function of exchange rate risk and country risk in
addition to expected currency appreciation or depreciation. The notebook discusses a study that looks at the
Mexican economy and breaks the interest rate differential into these three components.
For Critical Analysis: The political danger would most likely be referenced in the country risk. Note however,
that in so far as changes in a political environment may also influence economic policy and currency values,
one could make arguments that the political event may be reflected in all the components (i.e. it may also be
reflected in expected depreciation and in the exchange rate risk)
Instructor’s Manual — International Monetary and Financial Economics
56
ANSWERS TO END OF CHAPTER QUESTIONS
1.
International Financial Instruments:
a.
b.
c.
d.
2.
Global Bond: long term instruments issued in the domestic currency.
Eurobond: term is longer than one year and is issued in a foreign currency.
Eurocurrency: keyword is that it is a deposit.
Global equity: keyword is that it is a share.
Parity Conditions:
Using uncovered interest parity, R – R* = (S+1 – S) / S, given the left-hand-side is negative, we
would expect the right-hand-side to be negative, indicating a domestic currency appreciation.
b. Using relative PPP,  – *=e, given the left -hand-side is negative, we would expect the right-handside to be negative, indicating a domestic currency appreciation.
a.
3.
The domestic real interest rate is 5 percent less 2 percent, or 3 percent. The foreign real interest rate is
6 percent less 4 percent, or 2 percent.
4.
The condition does not hold as real interest rates are not equal. We would expect funds to flow into the
domestic country driving the real interest rate down and the foreign real interest rate down and the
foreign real interest rate up.
5.
Demand and supply schedules:
a.
b.
c.
The demand for the currency of the developing nation would rise, causing and appreciation of the
currency.
The supply of the currency of the developing nation would rise, causing a depreciation of the
currency.
Based on the answers in a and b above, one cannot say. We can only assume that capital restrictions
would partially insulate the value of the currency as capital flows are restricted.
6.
By uncovered interest parity (UIP), R – R* = (Se+1 – S)/S
For this to hold, however, there cannot exist a country risk premium or exchange rate premium. The basic
differences between the countries mentioned violate the assumptions of UIP. Therefore, it will not do a
good job of explaining the interest rate differential between the countries.
7.
Pegging would require the developing economy to follow the developed economy’s (assumedly sound)
monetary economic policy. Consequently, exchange rate risk should decrease, making UIP more likely to
hold.
Chapter Six
MULTIPLE CHOICE EXAM QUESTIONS
1.
A financial instrument is classified as belonging either to international capital markets or to international
money markets depending on whether it involves
A.
B.
C.
D.
the cross-border movement of physical capital versus financial capital.
the cross-border exchange of long-term versus short-term financial instruments.
fixed income investments such as bonds versus equities.
trade between adjacent versus nonadjacent geographical regions.
Answer: B
2.
The key role of an institutional investor is to
A.
B.
C.
D.
manage funds on the behalf of designated groups of individuals.
orchestrate transactions among large institutions.
provide a clearing house for funds in transition.
provide investment advice for firms and individuals.
Answer: A
3.
The level of international diversification in most investors’ portfolios has been found to be
A.
B.
C.
D.
nearly uniform.
falling in recent years.
much lower than theory would predict.
much higher in less-developed countries than in more industrialized countries.
Answer: C
4.
The lack of international diversification is often attributed to
A. a Lack of effort on the part of investors to seek out international investing opportunities.
B. the fact that most promising investment opportunities occur within the U.S.
C. the presence very little correlation among the rates of returns of assets originating in different
countries.
D. a perceived higher foreign risk in those markets with which investors are less familiar.
Answer: D
5.
Foreign exchange market activity is about ________ as the activity on the New York Stock Exchange.
A.
B.
C.
D.
the same.
twice the level.
seven times the level.
forty times higher.
Answer: D
57
Instructor’s Manual — International Monetary and Financial Economics
58
6.
The Euro markets are non-traditional in the sense that
A.
B.
C.
D.
the financing is carried out in a currency other than the local one.
they are completely unregulated.
they do not accept individual accounts.
they have experienced a recent slowdown in growth.
Answer: A
7.
The currency that individuals and businesses most often use to conduct international transactions is called
the
A.
B.
C.
D.
domestic currency.
vehicle currency.
unit of exchange.
Euro.
Answer: B
8.
The single currency that is to be adopted in Europe is called the
A.
B.
C.
D.
Euro.
ECU.
EMU.
DM.
Answer: A
9.
In addition to interest rate parity conditions, what type of evidence has been used to infer the degree of
capital market integration?
A.
B.
C.
D.
the degree of independence of a country’s central bank
the difference between a country’s nominal and real interest rates
the size of the nation’s debt relative to GDP
the high empirical correlation between domestic saving and investment
Answer: D
10. Research has shown that the differential between the Eurocurrency interest rate and the forward premium
are quite________ indicating that industrialized nation’s financial markets are ________.
A.
B.
C.
D.
small ; well integrated
large; well integrated
small; not well integrated
large; not well integrated
Answer: A
Chapter Six
59
11. The test of covered interest rate parity among less-developed nations
A.
B.
C.
D.
does an excellent job of forecasting the change in the exchange rate.
does an excellent job forecasting the forward rate.
fairs poorly, which indicates that their short-term capital markets are relatively open.
fairs poorly, which indicates that their short-term capital markets are relatively closed.
Answer: D
12. Assume that covered interest parity holds, the interest rate on a German bond is 3% and the interest rate on
a U.S. bond is 5%. Based on this we know:
A.
B.
C.
D.
F > S.
F < S.
individuals will only hold German bonds.
the German mark trades at a discount in the forward market.
Answer: A
13. Assume that covered interest parity holds, the interest rate on a German bond is 5% and the interest rate on
a U.S. bond is 3%. Based on this we know:
A.
B.
C.
D.
F > S.
F < S.
individuals will only hold U.S. bonds.
none of the above.
Answer: B
14. Assume that covered interest parity holds and that F < S. We therefore know that the U.S. interest rate is
________ the German interest rate.
A.
B.
C.
D.
less than
equal to
greater than
none of the above
Answer: A
15. A major difficulty with testing uncovered interest rate parity is determining
A.
B.
C.
D.
how to measure individuals’ expectations of the future spot rate.
which length of maturity to test.
whether to use nominal or real interest rates.
how the forward rate and future spot rate are related.
Answer: A
Instructor’s Manual — International Monetary and Financial Economics
60
16. Tests of uncovered interest rate parity indicate
A.
B.
C.
D.
a very close agreement with the theory.
sizable deviations form the theory.
that the theory is basically untestable since it depends on expected values.
that the data was poorly recorded.
Answer: B
17. The condition in which both covered and uncovered interest rate parity hold and the forward exchange rat
equals the expected future spot exchange rate is known as
A.
B.
C.
D.
the double parity condition.
the existence of arbitrage.
real interest rate parity.
foreign exchange market efficiency.
Answer: D
18. The distinction between Eurobonds and Euronotes is that
A.
B.
C.
D.
Eurobonds are long term financial instruments, whereas Euronotes are short too medium term.
Eurobonds are usually backed by the government, whereas Euronotes are not.
Eurobonds are of smaller denominations, whereas Euronotes are typically large denominations.
Euronotes carry coupons, whereas Eurobonds are pure discount instruments.
Answer: A
19. The real interest rate is defined as the
A.
B.
C.
D.
nominal interest rate minus the expected rate of price inflation.
nominal interest rate plus the expected rate of price inflation.
nominal interest rate divided by the expected rate of price inflation.
expected rate of price inflation minus the nominal interest rate.
Answer: A
20. The equation that shows the relationship between expected inflation, real interest rates, and nominal
interest rates is called the
A.
B.
C.
D.
interest rate parity equation.
Fisher equation.
GDP deflator.
net inflation index.
Answer: B
Chapter Six
21. Using the expression for purchasing power parity we can show that the difference in expected rates of
inflation between countries is equal to the
A.
B.
C.
D.
expected rate of deprecation or appreciation of the domestic currency.
sum of the nominal interest rates in the two countries.
sum of nominal interest rate plus expected inflation.
future spot rates on the currency exchange market.
Answer: A
22. An underlying assumption of the Feldstein-Horioka test is that
A.
B.
C.
D.
international arbitrage is limited by government by government intervention.
the Fisher equation must hold.
real interest parity holds in the long run.
megabanks deals principally in the domestic financial markets.
Answer: C
23. Deviations from real interest parity can be decomposed into deviations from
A.
B.
C.
D.
absolute purchasing power parity and relative purchasing power parity.
covered and uncovered interest parity.
covered interest parity and relative purchasing power parity.
relative purchasing power parity and uncovered interest rate parity.
Answer: D
24. In an environment with little or no capital mobility on would expect
A.
B.
C.
D.
a high negative correlation between a nation’s saving rate and investment rate.
a high positive correlation between a nation’s saving rate and investment rate.
a low positive correlation between a nation’s saving rate and investment rate.
no correlation between a nation’s saving rate and investment rate.
Answer: B
25. The reason we expect a nation’s saving rate and investment rate to be correlated is because of
A.
B.
C.
D.
the nation’s inability to attract foreign savings or investment.
large deficits, which lead to higher interest rates.
the fact that financial intermediaries coordinate both savings and investment.
the fact that the inflow of not imports will have a smoothing effect.
Answer: A
61
Instructor’s Manual — International Monetary and Financial Economics
62
26. A recent study conducted by Feldstein and Horioka found a correlation between savings and investment of
approximately
A. 1%.
B. 10%.
C. 50%.
D. 90%.
Answer: D
27. Which of the following is not an example of a frequently used Euro-instrument?
A.
B.
C.
D.
Eurobond
Euronote
Eurostock
Eurocommmercial paper
Answer: C