Title: Stability of fundamental parity conditions in international finance
Authors: Markus Moessler - University of Hohenheim (Germany) [presenting]
Abstract: The long-term stability of fundamental parity conditions in international finance is analyzed, in particular, the covered interest rate parity (CIP) condition. The CIP condition is based on the law of one price (LOP) on international financial markets and forms the basis for other fundamental parity conditions such as the uncovered interest rate parity (UIP) condition and the unbiased forward rate hypothesis. Recent studies found that the USD CIP condition held up well before but broke down after the Global Financial Crisis (GFC) of 2007-2008 and point to macroeconomic as well as financial explanations for this phenomenon. We propose to analyse the CIP condition in a vector error correction model (VECM) framework, which allows us to examine the stability of various relationships and trends driving international financial markets jointly. Moreover, whereas most studies focused on USD relationships we extend the analysis beyond USD relationships. This allows us to compare the effects of global factors, e.g., international financial stability, as well as local factors, e.g., national monetary policy, on fundamental parity conditions in international finance. In general, we confirm the result, that fundamental relationships in the international financial market changed after the GCF. However, no single cause can be identified, changes and potential explanations vary across currency pairs.