Having examined quantity criteria for market integration in the previous chapter, the next stage of our empirical discussion moves on to price criteria. Here we will encounter some venerable parity tests from the international finance literature: exchange-risk-free interest parity, real interest parity, and purchasing power parity. Compared to quantity criteria, such tests offer a seemingly more direct way to assess market integration. For reasons already given, however, changes in price differentials between two locations will track changes in market integration only if certain auxiliary assumptions hold true. These problems will be faced when we sum up our findings and encounter another set of caveats.

Exchange-risk-free nominal interest parity

Perhaps the most unambiguous indicator of capital mobility is the relationship between interest rates on identical assets located in different financial centers. The great advantage of comparing onshore and offshore interest rates such as these is that relative rates of return are not affected by pure currency risk. In principle, therefore, such interest differentials (when they exceed normal market transaction costs) represent pure arbitrage opportunities, absent some impediments to free international capital flow.

For much of the period we study here, a direct offshore-onshore comparison is impossible. However, the existence of forward exchange instruments allows us to construct roughly equivalent measures of the return to currency-risk-free international arbitrage operations.

For the period stretching from 1921 until the first half of 2003, we have monthly data on forward exchange rates, spot exchange rates, and nominal interest rates. We therefore can assess the degree of internationalfinancial-market integration by calculating the return to covered interest arbitrage between financial centers.