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Financial Market Integration Assessment | Economic Explorer


in a new article prepare Financial Integration Handbookedit Guglielmo Maria Caporale, This is Hiro I examine bond-based measures of financial market integration (thus, no quantitative stock/flow measures, nor banking integration).

In short, covered spreads have risen, but uncovered spreads appear to have narrowed. The evidence on real interest rate differentials is ambiguous.

figure 1: Covered spread, bps. Source: Cerutti et al. (2021).

See some discussion of this phenomenon here After 2016.

figure 2: Average absolute uncovered spreads, annualized, for advanced economy currencies (blue) and emerging market currencies (tan). Calculated using survey data.

See discussion on using survey data to extrapolate what is expected to happen, and how this changes our view of uncovered rate parity, hereand here; look Chinn and Frankel (2020).

image 3: Average absolute real spread (3-month rate, using ex-post inflation)

we come to the conclusion:

  • Covered interest parity, previously thought to apply to transaction costs, no longer applies after the global financial crisis. At one point, this was partly due to default risk (so measured returns no longer correlate to assets with the same default risk), and more recently due to changes in the regulatory regime that made hedging costly.
  • Undiscovered interest rate parity needs to be distinguished from the unbiased assumption—that is, the joint assumption of undiscovered interest rate parity and unbiased expectations. Once this is done, the evidence in favor of uncovered rate parity (and thus perfect capital fungibility) is much stronger.
  • Government bonds are distinguished not only by the degree to which their yields covariate with wealth or consumption, but also by their convenience yield. Given this, it is not surprising that nominal financial integration (defined as the equalization of nominal returns in terms of a common currency) has not yet been completed.
  • Ex-post short-term real returns have shrunk over time, but are still far from balanced (and appear to have reversed during the pandemic and its aftermath).

the whole paper is here.



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