IRP: Indian Rupee Vis-a-Vis Us Dollar

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Comparison of Interest rate differentials to exchange rate movement for Indian Rupee vis-a`-vis US Dollar| ICF |


Literature Review5
Interest Rate Parity6
Spot Exchange Rate Data:10
Forward Rate Data:10
Interest Rate Data for India:11
Interest Rate Data for US:11
Analysis and Discussion11
Deviations from Interest Rate Parity (DIRP):11
One Month Forwards:11
3 Month Forwards:13
6 Month Forwards:14
9 Month Forwards:15
12 Month Forwards16
Unit testing for validating stationary data17
Regression Analysis18
One-month forward18
Three-month Forward20
Six Month Forward21
Nine Month Forward22
Twelve Month Forward24
Analysis using Capital Inflows25

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. Real interest parity, uncoveredinterest parity and covered interest parity gives a indication of financial integration of economy.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. Literature Review

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...
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