Financial openness exists when residents of one country are able to tradeassets

with residents of another country, i.e. when financial assets are traded goods.
Aweak definition of complete financial openness, which one might refer to as
financialintegration, can be given as a situation in which the law of one price
holds forfinancial assets- i.e. domestic and foreign residents trade identical
assets at the sameprice. A strong definition would add to this the restriction that
identically definedassets e.g. a six-month Treasury bill, issued in different
political jurisdictions anddenominated in different currencies are perfect
substitutes in all private portfolios.

The degree of financial integration has important macroeconomic implications

interms of the effectiveness of fiscal and monetary policy in influencing
aggregatedemand as well as the scope for promoting investment in an
economy.The free and unrestricted flow of capital in and out of countries and the
everincreasingintegration of world capital markets can be attributed to the
process ofGlobalization. The benefits of such integration are liquidity
enhancement on one handand risk diversification on the other, both of which are
instrumental in makingmarkets more efficient and also facilitate smooth transfers
of funds between lendersand borrowers. India began a very gradual and selective
opening of the domesticcapital markets to foreign residents, including non-
resident Indians (NRIs), in theeighties. The capital market opening picked up pace
during the nineties.

.Three definitions of financial integration are as follows:

(i) Real interest parity hypothesis states that international capital flows
equalize real interest rates across countries.

(ii) Uncovered interest parity states that capital flows equalize expected rates
of return on countries’ bonds regardless of exposure to exchange risk.

(iii) Covered interest parity states that capital flows equalize interest rates
across countries when contracted in the same currency.

Only definition (iii) that the covered interest differential is zero is an unalloyed
criterion for “capital mobility” in the sense of the degree of financial market
integration across national boundaries. Condition (ii) that the uncovered interest
differential is zero requires that (iii) hold and that there be zero exchange risk
premium. Condition (i) that the real interest differential be zero requires
condition (ii) and in addition that expected real depreciation is zero.

The uncovered interest parity (UIP) theory states that differences

betweeninterest rates across countries can be explained by expected changes in
currencies.Empirically, the UIP theory is usually rejected assuming rational
expectations, and explanations for this rejection include that expectations are
irrational. There appears to be overwhelming empirical evidence against UIRP, at
least at frequencies less than one year. Other research shows that UIRP holds in
long term. The results of these long horizon regressions are much more positive
— the coefficients on interest differentials are of the correct sign, and most are
closer to the predicted value of unity than to zero. Research done by Ravi Bansal
and Magnus Dahlquistconclude that the often found negative correlation between
the expected currency depreciation and interest rate differential is, contrary to
popular belief, not a pervasive phenomenon. It is confined to developed
economies, and here only to states where the U.S. interest rate exceeds foreign
interest rates. Research done for emerging markets by Frank S. Skinner shows
that there isindeed violations in covered interest rate parity in the long-term
capital markets andthe source of these violations is credit risk rather than the
size of the economy orliquidity of the foreign exchange market. The covered
interest parity (CIP) postulates that interest rates denominated in different
currencies are equal once you cover yourself against foreign exchange risk.
Unlike the UIP, there is empirical evidence supporting CIP hypothesis. Empirical
studies by various researchers shows that the CIP holds in most cases on the
Eurocurrency market (where remunerated assets have similar default and
political risk characteristics) since the collapse of the Bretton Woods regime in
early 1970’s.

In the Indian context, Varma (1997) has undertaken an analysis of the covered
interest parity. He posits a structural break in the money market in India in
September 1995, with CIP become effective from that point on for the first time
in the Indian money market. The structural break itself is attributed to interplay
between the money market and the foreign exchange market. The period after
1995 is however witness to several deviations from the CIP. Varma has used
rates on Treasury bills, certificates of deposit and commercial paper and call
money rate to analyze the Indian money market.

One problem encountered in examining covered interest rate parity is a lack of

highquality observations on long-term interest rates the terms of which are
comparableacross different markets. A ready solution is the interest rate swap
market. Thismarket has evolved into one of the most important international
fixed income markets. Benefits of using swap interest rates are as follows:

a) swap terms and conditions arecomparable across different markets

b) swaps are liquid instruments so high quality information is available even for
long terms in emerging markets

c) swap rates areclosely related to the underlying national bond markets and
reflect the interest ratesavailable for borrowing and investment

In our analysis in this report we have not used swap rates as they are available
only for International swap dealers association members. Literature suggests that
zero coupon bond yields are close proxy for the interest rates.

Interest Rate Parity

Interest rate parity is an economic concept, expressed as a basic algebraic
identity that relates interest rates and exchange rates. The identity is theoretical,
and usually follows from assumptions imposed in economic models. There is
evidence to support as well as to refute the concept. In this report, we will
analyze the data available to find whether this concept can be supported or
refuted in case of India and US.

Interest rate parity is a non-arbitrage condition which says that the returns from
borrowing in one currency, exchanging that currency for another currency and
investing in interest-bearing instruments of the second currency, while
simultaneously purchasing futures contracts to convert the currency back at the
end of the holding period, should be equal to the returns from purchasing and
holding similar interest-bearing instruments of the first currency. If the returns
are different, an arbitrage transaction could, in theory, produce a risk-free return.
This can be shown as

(1+ irs) = (Frs/$/Srs/$) (1+ i$ )

Where

irs= interest rates in India

i$= interest rates in US

Frs/$= Forward exchange rate

Srs/$= Spot exchange rate

Looked at differently, interest rate parity says that the spot price and the
forward, or futures price, of a currency incorporate any interest rate differentials
between the two currencies assuming there are no transaction costs or taxes.IRP
is a manifestation of the Law of One Price (LOP)applied to international money
market instruments.

Being an arbitrage equilibrium condition involving the spot exchange rate, IRP
has an immediate implication for exchange rate determination. Reformulating
the IRP relationship in terms of spot exchange rate gives

S = [(1+i$)/(1+irs)] F

Above equation indicates that the forward exchange rate, the spot exchange rate
depends upon relative interest rates. All else equal, an increase in Indian interest
rates will lead to higher foreign exchange value of Indian rupee. This is so
because a higher Indian interest rates will attract capital to India, increasing the
demand for Indian rupee. In contrast, a decrease in Indian interest rates will
lower the foreign exchange value of Indian rupee.

In addition to relative interest rates, the forward exchange rates is an important

parameter in spot exchange rate determination. Under certain conditions the
forward exchange can be viewed as the expected future spot exchange rate
conditional on all relevant information being

Above equation indicates that the forward exchange rate, the spot exchange rate
depends upon relative interest rates. All else equal, an increase in Indian interest
rates will lead to higher foreign exchange value of Indian rupee. This is so
because a higher Indian interest rates will attract capital to India, increasing the
demand for Indian rupee. In contrast, a decrease in Indian interest rates will
lower the foreign exchange value of Indian rupee.

In addition to relative interest rates, the forward exchange rates is an important

parameter in spot exchange rate determination. Under certain conditions the
forward exchange can be viewed as the expected future spot exchange rate
conditional on all relevant information being available now

F = E(St+1| It)

Where St+1 is the future spot rate when the forward contract matures and It
denotes the set of information currently available. Hence the final relation will be
as follows

S = [(1+i$)/(1+irs)] E (St+1 | It)

Two things are noteworthy here that expectations play a key role in exchange
rate determination. Specifically, the expected future rate is shown to be a major
determinant of the current exchange rate when people expect the exchange rate
to go up in future, it goes up now. People’s expectations thus become self
fulfilling. Second, exchange rate expectations will be driven by the news event.
People form their expectations based on the set of information (It) they possess.
As they receive news continuously, they are going to update their expectations
continuously. As a result, the exchange rate will tend to exhibit a dynamic and
volatile short term behavior, responding to various news events. By definition,
news events are unpredictable, making forecasting future exchange rates an
arduous task.

When the forward exchange rate F is replaced by the expected future spot
exchange rate, we can rewrite IRP as

(irs – i$)= E(e)= [E(St+1) – St]/St

Above equation states that interest rate differential between a pair of countries is
approximately equal to the expected rate of change in the exchange rate. This
relationship is known as uncovered interest rate parity.

Although IRP tends to hold quite well, it may not hold all the times precisely all
the times for at least two reasons: transaction costs and capital controls. In
reality, transaction costs do exist. The interest rate at which the arbitrager
borrows, ia, tends to be higher than the rate at which he lends, ib, reflecting the
bid-ask spread. Likewise, there exists a bid-ask spread in the foreign exchange
market as well. Because of the transaction costs, the IRP line can be viewed as
included within a band around it. The width of band depends upon the size of
transaction cost.

Another major reason for deviations from IRP is capital controls imposed by
governments. For various macroeconomic reasons, governments sometimes
restrict capital flows, inbound and/or outbound. Governments achieve this
objective by means of jawboning, imposing taxes or even outright bans on cross
border capital movements. These control measures imposed by governments can
be effectively impair the arbitrage process and as a result, deviations from IRP
may exist.

Deviations from IRP (DIRP) can be calculated as follows:

DIRP = [S(1+irs)/ (1+i$) F] - 1

If IRP holds strictly, deviations from it would be randomly distributed, with

expected value of zero.

When IRP does not hold good, the situation gives rises
to covered interest rate parity.Assume that
individuals are risk averse. Such anindividual would
like to cover himself for any unexpected currency
fluctuationduring the tenure of the deal. Given the
forward contract market, he wouldpurchase a
forward contract and use the exchange rate
mentioned in the contract.Then any difference in
interest rate should be equated to forward premium.
Any deviation from CIP would suggest that the
markets are inefficient,regulations like capital
controls exist and costs like sovereign risk Regression
Analysis
Regression model for validating the relationship between interest rate differential and forward
premium can be estimated as

Forward premium = a + b * interest rate differential +error

After validating the time series data for various maturity of forwards, we performed the
regression analysis to estimate the relationship and also find the explained variation of
forward premium with respect to interest rate differential which is given by R-square
parameter of the regression analysis. We also plotted the forward premium and interest rate
differential with respect to time to find the variation with time and get the trend of both the
variables with time(Interest rate differential is multiplied by 10 to get clear trend)

Analysis
One-month forward
For one month forward, the unit test for validating stationary time series data shows
deviations from basic assumption.

Coefficie Standar Lower Upper Lower Upper

nts d Error t Stat P-value 95% 95% 95.0% 95.0%

- -
Interc 0.00132 0.00353 0.37489 0.70953 0.00580 0.00845 0.00580 0.00845
ept 5955 6861 6027 8806 2119 4029 2119 4029
Forwa
rd - - - - - -
Premi 0.71424 0.14347 4.97807 1.03655 1.00340 0.42508 1.00340 0.42508
um 6068 8264 8543 E-05 7506 4631 7506 4631

Coefficie Standard Lower Upper Lower Upper

nts Error t Stat P-value 95% 95% 95.0% 95.0%
-
0.00038 0.00020 1.8684 0.0683 3.058E 0.0008 -3.058E- 0.00080
Intercept 8982 8181 764 628 -05 085 05 8544
- - - -
Interest 0.08858 0.05604 1.5805 0.121 0.2015 0.0243 0.20154 0.02437
Rate 6245 8638 245 1496 449 724 4851 236

As shown in the above tables, p-value for forward premium is less than 0.05 where as it is
more for interest rate differential. Hence, data is not perfect stationary. As one series is
stationary, we proceed with the regression analysis as atleast one of the data series is
stationary in nature.

Regression equation for one month forward is as follows:

forward premium = 0.0358 -9.392(Interest rate differential)

Regression Statistics
Multiple R 0.4575725
0.209372
R Square 6
Adjusted R Square 0.1918031
0.0220488
Standard Error 5
Observations 47
R-square value shows the explained variation as close to 21% only which is very low. The
trend can be shown as
As we can see in the trend analysis, that forward premium and interest rate differential
shows a opposite trend from mid of 2007 to the start of 2009. This can be attributed to
economic downturn when free capital mobility was hampered between India and US as US
restored to more conservative approach.

Three-month Forward
Similar to one month forward, unit testing shows the same trend when forward premium data
is not stationary in nature where as interest rate differential data is stationary in nature.

Coefficie Standard Lower Upper Lower Upper

nts Error t Stat P-value 95% 95% 95.0% 95.0%
- -
0.00080 0.005093 0.15836 0.87492 0.00947 0.01108 0.00947 0.011085
Intercept 66 5 5 82 25 57 25 7
- - - - - -
FORWARD 0.26100 0.102656 2.54254 0.0147 0.46817 0.05383 0.46817 0.053839
PREMIUM 94 73 49 797 9 97 9 7

Coefficie Standard Lower Upper Lower Upper

nts Error t Stat P-value 95% 95% 95.0% 95.0%
- -
0.00121 0.000612 1.98129 0.05412 2.253E- 0.00244 2.253E-
Intercept 37 56 4 99 05 99 05 0.0024499
- - - -
INTEREST RATE 0.09984 0.055247 1.80725 0.0778 0.2113 0.01164 0.2113
DIFF 57 14 55 889 39 75 39 0.0116475
As shown in the above tables, p-value for forward premium is less than 0.05 where as it is
more for interest rate differential. Hence, data is not perfect stationary. As one series is
stationary, we proceed with the regression analysis as atleast one of the data series is
stationary in nature.

Regression equation for three month forward is as follows:

 forward premium = 0.112 -10.039(Interest rate differential)
Regression Statistics
0.7317371
Multiple R 2
0.535439
R Square 21
0.5246354
Adjusted R Square 7
0.0339205
Standard Error 2
Observations 45
The explained variation is good in this case which is close to 54%. This model shows a better
estimate than one month forward. The trend analysis is as follows

As we can see in the trend analysis, that forward premium and interest rate differential shows
a opposite trend from mid of 2007 to the start of 2009. This can be attributed to economic
downturn when free capital mobility was hampered between India and US as US restored to
more conservative approach.

Six Month Forward

Unit testing for time series data for 6 month forward shows that both the data series are
stationary in nature.

Coefficie Standar Lower Upper Lower Upper

nts d Error t Stat P-value 95% 95% 95.0% 95.0%
- - -
0.00044 0.00503 - 0.93073 0.01062 0.00974 0.01062
Intercept 06 69 0.08748 76 86 74 86 0.0097474
- - - -
FORWARD 0.08448 0.06244 1.35300 0.1838 0.21079 0.04181 0.21079
PREMIUM 71 42 23 466 24 82 24 0.0418182

Coefficie Standar Lower Upper Lower

nts d Error t Stat P-value 95% 95% 95.0% Upper 95.0%
 - -
0.00240 0.00126 1.89886 0.06499 0.00015 0.00497 0.00015
Intercept 76 79 51 84 7 22 7 0.0049722
- - - -
INTEREST RATE 0.09734 0.05755 1.69129 0.0987 0.21375 0.01907 0.21375
DIFF 21 48 52 579 76 34 76 0.0190734
As shown in the above tables, p-value for forward premium is more than 0.05 as well as for
interest rate differential. Hence, data is perfect stationary. As both series are stationary, we
proceed with the regression analysis.

The regression model for 6-month forward is as follows

forward premium = 0.1861 -8.334(Interest rate differential)

Regression Statistics
Multiple R 0.773163168
0.59778128
R Square 4
Adjusted R Square 0.587725816
Standard Error 0.051177283
Observations 42
Explained variation in this case is close to 60% which shows a good relation. The trend
analysis is shown as follows

As we can see in the trend analysis, that forward premium and interest rate differential
shows a opposite trend from mid of 2007 to the start of 2009. This can be attributed to
economic downturn when free capital mobility was hampered between India and US as US
restored to more conservative approach
Nine Month Forward
Unit testing for time series data for 9 month forward shows that both the data series are
stationary in nature.

Coefficie Standar Lower Upper Lower Upper

nts d Error t Stat P-value 95% 95% 95.0% 95.0%
- - - -
0.00254 0.00533 0.47667 0.63647 0.01336 0.00827 0.01336
Intercept 26 4 41 5 04 52 04 0.0082752
- - - -
FORWARD 0.06542 0.04949 1.32195 0.1945 0.16580 0.03494 0.16580
PREMIUM 85 39 17 231 68 97 68 0.0349497

Coefficie Standar Lower Upper Lower

nts d Error t Stat P-value 95% 95% 95.0% Upper 95.0%
- -
0.00350 0.00193 1.81349 0.07809 0.00041 0.00743 0.00041
Intercept 78 43 06 98 51 08 51 0.0074308
- - - -
INTEREST RATE 0.09730 0.05828 1.66945 0.1037 0.21550 0.02090 0.21550
DIFF 05 29 22 025 38 27 38 0.0209027
As shown in the above tables, p-value for forward premium is more than 0.05 as well as for
interest rate differential. Hence, data is perfect stationary. As both series are stationary, we
proceed with the regression analysis.

The regression model for 9-month forward is as follows

forward premium = 0.2068 -6.227(Interest rate differential)

Regression Statistics
0.67142029
Multiple R 2
0.4508052
R Square 08
Adjusted R 0.43596210
Square 6
0.08049568
Standard Error 1
Observations 39

Explained variation in this case is close to 45% which shows a linear relation. The trend
analysis is shown as follows
As we can see in the trend analysis, that forward premium and interest rate differential
shows a opposite trend from mid of 2007 to the mid of 2009. This can be attributed to
economic downturn when free capital mobility was hampered between India and US as US
restored to more conservative approach

Twelve Month Forward

Unit testing for time series data for 12 month forward shows that both the data series are
stationary in nature.

Coefficie Standar t Stat P- Lower Upper Lower Upper 95.0%

nts d Error value 95% 95% 95.0%
Intercept - 0.00711 - 0.72054 - 0.01191 - 0.0119167
0.00256 99 0.36080 63 0.01705 67 0.01705
89 29 44 44
FORWARD - 0.05566 - 0.19407 - 0.03946 - 0.0394622
PREMIUM 0.07379 71 1.32561 02 0.18704 22 0.18704
33 85 88 88

Coefficie Standar Lower Upper Lower

nts d Error t Stat P-value 95% 95% 95.0% Upper 95.0%
- -
0.00269 1.74661 0.09000 0.00077 0.01019 0.00077
Intercept 0.00471 66 68 71 64 64 64 0.0101964
- - - -
INTEREST RATE 0.09685 0.06063 1.59731 0.1197 0.22022 0.22022
DIFF 52 61 79 277 04 0.02651 04 0.02651

As shown in the above tables, p-value for forward premium is more than 0.05 as well as for
interest rate differential. Hence, data is perfect stationary. As both series are stationary, we
proceed with the regression analysis.
The regression model for 12-month forward is as follows

forward premium = 0.1744 -4.094(Interest rate differential)

Regression Statistics
Multiple R 0.508144918
0.25821125
R Square 7
Adjusted R Square 0.236393941
Standard Error 0.112197183
Observations 36

Explained variation in this case is close to 25% which shows a weak relation. The trend
analysis is shown as follows

As we can see in the trend analysis, that forward premium and interest rate differential
shows a opposite trend from mid of 2007 to the start of 2009. This can be attributed to
economic downturn when free capital mobility was hampered between India and US as US
restored to more conservative approach

As shown in the data analysis that IRP holds for 1-month to 12-month IRP, regression
analysis shows the liner variation in IRP. The trend analysis of all the forward premium and
interest rate differential shows the deviation for all period forwards which can be contributed
to global macroeconomic crisis which had its direct in free capital mobility between India and
US. Even before the crisis, as there was not perfect capital mobility in India, the low value of
R-square can be attributed to macroeconomic policy of both India and US.
Analysis using Capital Inflows
The deviations from Interest Rate Parity (DIRP) have been calculated for the years 2006 to
2010. The deviations are equal to the difference between the values of actual forward rates
and calculated value of forward rate using the IRP formula. If IRP holds, then the expected
value of DIRP should equal zero. The calculated deviations are as follows:

Year Average Deviation Standard Deviation of

from IRP Errors
2006 0.0475 0.142853637
2007 -0.0788 0.415671665
2008 -0.7533 0.569689308
2009 -0.3131 0.250006667
2010 -0.3734 0.255550415

The data indicates that the mean error (Expected value of DIRP) is highest for the year 2008-
09 as compared to other years. Interest rate parity theory assumes free capital mobility
between two countries. Restriction on free capital mobility causes deviations from the IRP.
During the period 2008-09 the global economy witnessed a severe recession. This caused
heavy capital outflows from the Indian markets as foreign institutional investors (FII) withdrew
the money invested in Indian markets. Although the interest rates in India have always been
higher compared to the US, deviation from IRP could be observed due to the capital outflows
from the economy instead of capital inflows. The foreign investment flows are outlined as
follows:

Year Direct Portfolio Total (USD

Investment Investment Million)
(USD million) (USD Million)
2006-07 22,826 7,003 29,829
2007-08 34,835 27,271 62,106
2008-09 35,180 –13,855 21,325
2009-10 37,182 32,375 69,557
Foreign Investment Flows 2006-2010, (Source: RBI Website)
Foreign Investment flows witnessed a marked decrease during the period 2008-09. This is
consistent with the larger deviations observed from the interest rate parity.

Conclusion
From the above analysis we can conclude that deviations from IRP are not statistically
significant in the short run. More comprehensive analysis can be carried out using bid-ask,
individualborrowing constraints are not accounted for. Forward rates, in free
markets, are strictly a mathematical calculation based on interest rate
differentials between countries. When Indian interest rate is higher than that of
US, INR tends to be at a forward discount in terms of the USD. Conversely, when
Germany's domestic interest rate is lower than that of US, Euro tends to be at a
forward premium. However, the forward rate so worked out is no indicator of the
future trend of the currency values.

The relationship between the interest differential and forward margins is a stable
one. Should it get disturbed, it will throw open arbitrage opportunities and
arbitrage transactions will restore the interest parity. It is worth emphasizing that
the interest parity principle holds good in a free market wherein exchange and
interest rates will be determined purely by forces of demand and supply of the
respective currency. However, the interest parity principle does not hold good as
far as the forward exchange rate of INR against the USD is concerned due to the
following factors.

a. Capital account convertibility does not exist in India on full scale basis,
though Indian citizens / investors are enjoying full current account and partial
capital account convertibility. Hence, capital can't move freely between India and
overseas which disturbs the interest parity.
b. Foreign Direct Investment (FDI) and Portfolio investments are long term
and short term investments respectively from Foreign Institutional Investors (FII).
Though long term investments may not affect the forward premia much, certainly
the short term investment flows from FIIs do affect the forward premia.

c. Inflation differential affects the forward premia mainly through demand for
and supply of currencies. When Indian inflation is more than that of the US,
Indians tend to import more goods and services from US which would result in
deficit in Current Account. This will exert upward pressure on the exchange rate
both on spot and forward rate of USD vis-à-vis INR.

d. RBI's regulations in respect of ECB / FCCBs and ADR / GDRs also have
considerable impact on forward premia. Indian corporates mobilize medium / long
term funds through ECB / FCCB routes, which generally have repayment tenors
ranging from 3 to 7 years. In case of FCCBs, repayment will take place only when
the investor does not convert the bonds into equity shares of the company that
issued. When repayments of the above are made by the corporates, they book
forward contracts in advance, which drive the forward premia upwards. In the
forward market, contracts can be booked upto 12 months without any problem.
Forward contract for a tenor beyond 12 months is not liquid. However, it is
possible to book the forward contracts even for five years, but it is difficult to
predict market behaviour for longer period; so the markets are comfortable
operating on half yearly rollover basis for which a fee being collected on each
rollover. As per RBI's statistics, Indian companies borrowed nearly USD 31 billion
overseas during the FY 2007-08 as against USD 25 billion in the previous FY
2006-07.

e. As India does not have any established inter-bank term money market and
MIBOR is not considered as a benchmark lending rate in the domestic market on
the lines of LIBOR in the international market, Banks and Financial Institutions
increasingly rely on Repo rates / Bank rates announced by RBI for the borrowing /
deployment of their funds. As Repo rates / Bank rates are policy rates of RBI,
announced from time to time, and are not entirely driven by the market,
arbitraging opportunities may arise for the international investors, which increase
the forward premia.

f. Forward premia will also be affected by huge positions in USD - INR

derivatives viz., Mumbai Inter-bank Forward Offer Rate (MIFOR), Interest Rate
Swaps (IRS) and Non Deliverable Forward contracts (NDF). In the absence of huge
volumes in these derivatives, demand for forward contracts will decrease, which
will have an impact on forward premia.
g. Global oil prices are currently hovering around $ 122 a barrel. For India,
this means a daily foreign exchange requirement to the extent of USD 300 million
a day for crude imports alone. Payments by Indian oil companies for import of
crude affect spot rate more than the forward rate. Though Indian oil companies
don't cover their import payables much in the forward market beyond 3 months,
their transactions.