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Financial Market
Integration
A Summary of Parity Conditions
Covered Interest Parity
• Covered interest parity is a condition that
relates interest differentials to the forward
premium or discount.
• It begins with the interest parity condition:
(1+R) = (1+R*)(F/S)
• The condition can be rewritten, and with a
slight approximation, yields:
R - R* = (F-S)/S.
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Uncovered Interest Parity
• UIP is a condition relating interest differentials
to an expected change in the spot exchange
rate of the domestic currency.
• If a savings decision is uncovered, the
individual is basing their decision on their
expectation of the future spot exchange rate.
• The expected future spot exchange rate is
expressed as Se+1.
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Uncovered Interest Parity
• Using this expression for the expected
future spot rate, UIP can be written as:
e
R – R* = (S +1 – S)/S.
• In words, the right-hand-side of the UIP
condition is the expected change in the spot
rate over the relevant time period.
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The Fisher Effect
• The Fisher Effect is a condition relating
interest rates and prices.
• It postulates that the nominal interest rate
for a given time period is equal to the real
interest rate plus the rate of inflation that is
expected to prevail over that period.
• i = r + 
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The Fisher Effect
• Let d denote the rate for the domestic
country and f denote the rate for the foreign
country.
• id = rd + Ed and if = rf + Ef
• Then id - if = (rd - rf) + (Ed - Ef)
• If the real rate is constant and equal across
both countries,
• id - if = Ed - Ef
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ex ante PPP
• Recall that relative PPP is:
So = d - f
• Then ex ante PPP is:
ESt = Ed - Ef
• So
ESt = Ed - Ef = id - if
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Real Interest Parity
• Using, ESt = Ed - Ef = id - if, we can
focus on the last two terms to form the real
interest parity condition. Adding if to each
side and subtracting Ed from each side of
the equation we have:
(id - Ed) = (if - Ef).
• That is, when parity holds, real interest rates
are equal across countries.
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Real Interest Parity
• Again, using ESt = Ed - Ef = id - if, we
can also write an expression relating the real
exchange rate to the real interest rate by
subtracting the middle term from each side.
ESt - (Ed - Ef) = (id - Ed) - (if - Ef).
• That is, the real interest differential should
equal expected real exchange rate
movements.
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Feldstein - Horioka
• Savings and Investment Relation
• Based on a closed economy income
condition:
y = c + i + g.
• Rearrange as:
y - c - g = i.
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Feldstein - Horioka
• Rearranged as:
y - c - g = i.
• Note that y - c - g equals savings, s. Then:
s = i.
• In a closed economy, domestic investment
must correlate with domestic saving.
• Correlation coefficient would be significant
close to unity in value.
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