Evidence on Financial Globalization and Crises: Interest Rate Parity

Abstract

The Interest Rate Parity (IRP) relationship is one of the most relied upon indicators of financial globalization. IRP plays such a key role in global macroeconomic models that it is taken as a benchmark for perfect capital mobility between markets. In this paper, we review the theoretical basis and historical origins of the interest rate parity relationship. Empirical evidence supporting IRP became so wide-spread that by the start of the 21st century, economists and financial professionals essentially took IRP for granted. However, with the start of the global financial crisis in summer 2007 deviations from IRP increased significantly. Empirical evidence suggests that deviations can be linked to greater credit and counterparty risk among bank dealers, and a reduction in risk capital, as well as wider bid-ask spreads in currency markets. In the aftermath of the global financial crisis, deviations from covered interest parity have increased considerably relative to a decade ago. Calibrating whether these deviations are efficient market violations, or simply a reflection of greater costs and risks, is a new challenge for financial economists.