In this paper we make use of the uncovered interest rate parity (UIRP) relationship to examine the extent that the liberalization of emerging financial markets has resulted in the integration of developing countries’ currency markets into the international capital market. Previous tests of the impact of liberalization on the integration of emerging markets capital markets into world financial markets are confined to equity markets, ignoring currency markets that arguably are more important in determining the success of financial liberalization. We find that, in general, deviation from UIRP in the emerging markets is systematic in nature and that a significant part of emerging market currency excess returns is attributable to time-varying risk premium. Importantly we also find that these countries’ currency deposits provide U.S. (equity) investors the benefits of international diversification. Our results also show that for some markets, liberalization improved (worsened) investors’ perception of growth opportunity while reducing (increasing) investors' perception of the probability of financial distress. Finally, while several countries benefited from liberalization and have become more integrated into the world capital market, the experience is country specific.
JEL classification: F21, F31, F36
Keywords: capital market integration, uncovered interest rate parity (UIRP), financial liberalization, GARCH model
The authors gratefully acknowledge the Federal Reserve Bank of Atlanta for research support in the later stages of this project. They also thank Gayle Delong, Jerry Dwyer, Jim Lothian, and Michael Melvin for helpful comments and the University of Rome, Bentley College, the University of Southern Florida, and participants at the Tor Vergata, Italy, Conference on Banking and Finance for helpful suggestions. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
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