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Capital market integration over the past decade: The case of the US dollar
Journd of International Money and Finance (1987). 6, 21 j-225
Capital Market Integration over the Past Decade: The Case of the US Dollar PEGGY E. SWANSOS Department of Finance, University of Texas at Arlington, USA
Arlington,
TX
760 19,
This study investigates changing capital market integration over the decade 1973-83 as measured by the relationship between Eurodollar and domestic US dollar yields. The findings reveal that capital market
integration
has increased appreciably
since the end of 1981.
Evidence has been mounting that world capital markets are becoming increasingly integrated. Although closer relationships among the world’s capital markets result in a higher level of efficiency on a global scale, the reduction in capital market segmentation diminishes the ability of governments to achieve independent economic policies. In the past, the United States, together with much of the rest of the world, generally considered the US market to be sufficiently isolated or dominant that independent policies could be effectively pursued. This assumption Numerous studies have investigated the is becoming highly questionable. independence of the US market, but diverse approaches, different statistical techniques, and noncomparable data, either by type or period covered, have prevented a determination of changes in the degree of capital market integration over time. This study investigates changes in the relationship between US dollar returns in the United States and in external dollar markets, on a yearly and biyearly basis, over the period 1973-83, inclusive. Before the existence of the Eurocurrency markets, studies analyzing capital market integration were hampered by differing national money market regulations and constraints and by problems related to foreign exchange rate impacts on different currency denominated asset yields. Despite these problems, responsiveness of short-term capital flows to interest-rate differentials (and changes in the differentials) indicated some degree of capital market integration. Virtually all work, however, assumed or found that the US money market was relatively isolated from external money market events. The development of offshore markets, which has allowed more efficient testing, appears to have decreased US independence, but only recently has the effect been studied explicitly. Early works have been criticized in two aspects. First, they investigated one-way causality only-from the US dollar market to the Eurodollar market, and feedback 0261-5606/87/02/021S-11503.000 1987 Butterworth & Co (Publishers) Lrd
216
Capital
Market
Integration ot’er the Past Decade
effects were ignored. Second, the US rate of return had to be measured by some less than ideal proxy, usually the US Treasury Bill rate. No comparable deposit rate for Eurodollar deposits existed in the USA prior to 1973 when interest rate ceilings began to be removed. Hendershott’s original contribution (1967) concluded that, for the period 195764, the Eurodollar rate adjusted completely to changes in the US Treasury Bill rate, but the required adjustment period was roughly one year; the first month’s impact was approximately 20 per cent of the total. However, applying Hendershott’s estimated adjustment coefficients, 95 per cent adjustment required 22 months using monthly data and seven quarters using quarterly data. Kwack’s (1971) study estended Hendershott’s work by considering foreign rates. Using Hendershott’s formulation and assuming that foreign rates remain constant, Kwack found that, for the period 1960111-67IV, three quarters were necessary to achieve 95 per cent of the Eurodollar adjustment to US Treasury Bill rate changes. When foreign rates were allowed to vary, Kwack found less than full adjustment. Thus, identical techniques and measurements revealed more rapid adjustment of offshore dollar markets to changes in US market yields during the 1960-67 period than during the 1957-64 period. Unfortunately, later studies are not directly comparable. Giddy et al. (1979) were among the first to substitute Certificate of Deposit rates for Treasury Bill rates as the appropriate measure of US returns to compare to Eurodollar deposit rates. Another break from earlier studies was their attempt to show that the Eurodollar market was an integral part of the total dollar market and not merely a market determined by US rates. Thus introducing the idea of feedback effects, they concluded that the US market, because of domestic regulations and constraints, was less flexible than the Eurodollar market and responded more slowly to external changes than the Eurodollar market. Several recent studies of the interest-rate transmission mechanism have explicitly investigated the strength of feedback effects to the US market. Kaen and Hachey (1983), using Granger causality tests, found, for the period 1974-81 and based on three measures of US returns-US Treasury Bills, commercial paper, and Certificates of Deposit -that the domestic dollar market responds more quickly to changing conditions in the Euromarkets than conversely. This finding disagrees with that of Giddy et al. Hartman (1984), comparing a 1971-74 period to a 1975-78 period, found no significant impacts of external forces on the US market during the early period but highly significant impacts during the latter period. He thus concluded that feedback effects were a recent phenomenon.
I. Methodology Granger causality tests are selected for determining the degree and direction of causality between the US money market and the external dollar market. The advantages of these as opposed to other available tests have been shown.’ By including past, present, or future values of a variable, the approach allows one to determine whether or not forecast errors can be reduced for that variable. Thus direct causality, reverse causality, and contemporaneous adjustments can be studied for any two money market rate series. Classical ordinary least squares estimates may be biased as a result of the inclusion of lagged dependent variables as independent variables in the regression
PEGGY
217
E. SWASSON
equations. Thus, standard tests of statistical significance may not be applicable. If serial correlation of the error term or correlation between the lagged dependent variables and the error term is a problem, Wald’s test’ will provide the necessary test statistic. For ease of testing if these problems occur, the Granger test is formulated on the basis of restricted and unrestricted equations. The restricted equation contains only lagged values of the dependent variable; the unrestricted equation contains lagged values of both the dependent variable and the second series of yields. The two series tested are 3-month yields as measured by US Certificates of Eurodollar deposit rates, ES, and by yields on negotiable Deposit, CD. Defining all variables as first differences, the equations can be written as:
ES, = a +
(2)
ES, = a +
c
b,(B),_, +e,
E b,(a),_, + IX 4(CD>,-, +e, ,=I
i=l
(3)
CD, = a+ 5 b,(CD),_; +e, CD, = a + C b;(CD),_, + i=l
x 4(E$>,_;+e, i=l
where n identifies the number of lags. Equations (1) and (2) test for causality from the US domestic market to the external market; equations (3) and (4) test for reverse causality. If the direction of impact is that given in (1) and (2), some of the coefficients of the CD terms in (2) should be significantly different from zero; (3) and (4) describe the opposite directionality, and some of the dj terms in (4) should be significantly different from zero if feedback effects exist. If all d, are zero (in both equations (2) and (4)), the two interest-rate series are independent or contemporaneously determined. To test for contemporaneous determination, equations (2) and (4) are reestimated with current values of CD and ES, respectively, included as independent variables. II. Tests for Direct Causality,
Reverse Causality, Determination
and Contemporaneous
If capital market integration is increasing, a more rapid speed of adjustment requires shorter observation periods. Thus the basic data set is comprised of daily observations of 3-month maturity yields on Eurodollar deposits and on negotiable Certificates of Deposit during the period January 1, 1973 through December 31, 1983. Three-month maturities are selected because of the large volume of transactions in both markets at this maturity. The depth and breadth of these markets facilitate arbitrage activities. a Changes in the transmission mechanism are investigated by dividing the basic data set into ten one-year and five two-year data sets. Unexpectedly large responses in the two markets to daily changes in yields suggested that the same tests be conducted for verification purposes with weekly observations. The weekly observations used are the last day of the week values rather than averages for the week.
218
Capital Alarket Integrationowr tbc Past Decade
Before equations (l>-(4) can be tested using the various data sets of daily observations, one slight modification must be made because Eurodollar and CD deposit rates are not quoted identically. In the Eurodollar market, prior to October 1981, delivery for deposits occurred two business days after the transaction resulting in quoted rates in the offshore market actually being available two days after the quote. CD rates, however, are available on the day of the quote. Therefore, to be comparable, CD, must be paired with ES,_* during most of the period. For the remainder of the period, CD, is comparable to ES,. The lags selected for testing the daily data sets are one, five, and ten days. Five-day lags approximate weekly effects and ten-day lags approximate semimonthly effects. Although these periods are not long enough to expect completion of the adjustment process, they should be adequate to detect direction of causality. The longer the period considered, the greater the probability that influences other than changes in yields are affecting the results. Fortunately, the tests are not highly sensitive to the number of lags for data sets which have not been prefiltered (Kaen and Hachey, p. 331). For the weekly data sets, CD, is the appropriate counterpart of E$, and equations (l)-(4) are tested as presented above. The lags chosen are one, two, and four weeks. Again, longer periods are avoided because of the unidentifiable estraneous influences in the two yield series. Initial tests provided only slight indications of biased estimates. Later tests revealed somewhat stronger problems. Thus, for consistency, both the Joint Fand Wald test statistics are reported throughout. The first series of tests use the daily observation periods. Table 1 sets forth the test. statistics for direct and reverse causality for one-, five-, and ten-period lags. Until 1982, strong impacts of changes in CD yields on changes in Eurodollar yields is evident from the equations using Eurodollar returns (E$) as the dependent variable. Evidence of feedback effects (or reverse causality), shown by the equations using Certificate of Deposit yields (CD) as the dependent variable, is weaker but gaining strength over time. With a one-day lag, the direct impacts are significant at 0.01 for 1977 and 1980 only. These years were basically characterized by ample liquidity in international capital markets, generally falling or volatile interest rates, and unstable foreign exchange markets. The first two events would be expected to further capital market integration because of increased competition among both demanders and suppliers of funds; the impact of volatile exchange rates is less clear. No direct causality is indicated for the last two years. Reverse causality, on the other hand, is highly significant for 1982 and 1983. Table 2 sets forth the test results for contemporaneous determination; that is, current values of the independent variable are included in equations (2) and (4). Thus, the Joint F and the Wald test statistics are measuring statistical significance of differences between pairs of equations where one equation does and one equation does not contain current values of an independent variable. If the adjustment is contemporaneous+ a significant improvement in SSE should occur when the current value of the .independent variable is added to the regression equation. Because simultaneous determination yields identical test statistics when ES and CD are the dependent variables, the values are each only reported once. Little evidence exists of contemporaneous adjustment during the early years except for 1975 which appears to be unique. The severe recession in major industrial countries, the relaxation of US monetary restraint, and the fall of
219
PEGGY E. SW.~SSOS TABLE 1. Direct and reverse causality-one-year periods. Test statistics restricted and unrestricted equations (daily observations). One-period Year
Wald
E$ as the dependent
0.528 2.234 0.441 12.318** 3.424 4.565* 75.346** 0.550 1.592 0.015
0.522 2.204 0.440 12.159** 3.381 4.507* 74.392** 0.543 1.571 0.102
lags
Joint F
Wald
Joint F
Direct: 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
Five-period
lag
8.467** 5.724* * 7.306** 13.064** 10.161** 36.599** 54.272** 40.744** 0.450 0.353
2.743 0.002 0.857 5.023* 0.035 0.984 0.727 5.573* 18.285** 39.167**
5.447* 1.443 0.871 5.993* 0.145 1.214 0.894 5.644* 18.517** 39.711**
2.421* 0.184 0.443 1.003 0.188 2.156 1.338 2.330* 6.637** 14.414**
Ten-period Joint F
lags K’ald
variable -!4.430** 29.978** 38.342** 68.557** 53.318** 192.062** 284.803** 213.637** 2.357 1.859
Reverse: CD as the dependent 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
for pairs of
4.812** 3.727** 3.589** 6.930* * 6.195** 17.171** 28.848** 21.916** 0.470 0.649
53.004**
41.054** 39.530*” -6.328** 68.237** 189.127** 317.751** 2-10.973** 5.172 7.138
variable 13.319* 3.153 3.599 6.032 2.028 12.374* 7.209 12.216* 34.801** 75.613**
1.492 0.765 0.408 1.016 0.783 2.009* 2.073* 1.794 4.096** 9.851**
16.878 8.750 A.678 11.690 11.413 23.453*’ X.838* 19.719* -L&.740** 108.406**
* Significant at 5 per cent. ** Significant at 1 per cent.
Eurodollar rates to their 1972 level may partially esplain these results. The last two years, however, reflect strong contemporaneous determination. In order to better estimate market changes, Tables 3 and 4 report the results of tests for direct and reverse causality and for contemporaneous determination, respectively, over two-year periods. Daily observations still comprise the data sets. The longer time periods provide stronger indications of direct causality until 1982 (Table 3) and increasing feedback effects are reflected by all three lag measures. Based on the Wald test, contemporaneous determination is sporadic (Table 4). The strong indications of direct causality indicated by five- and ten-period lags using daily data (Tables 1 and 3) suggest that much of the adjustment in Eurodollar rates occurs within one or two weeks after a change in US rates. For this reason, the tests are repeated using weekly observations. The lags tested are one, two, and four periods. Thus the longest lags include roughly monthly impacts. Table 5 sets forth the direct and reverse causality results for weekly observations. The findings are very different from those with daily observations as shown in
220 TABLE
Capital iClarket Integration over the Past Decade 2. Contemporaneous determination-one-year restricted and unrestricted equations One-period
Year 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
Joint
F
Five-period
lag Wald
4.765* 10.145** 0.480 0.162 0.119 5.664* 2.490 0.202 273.324** 86.695**
periods. Test statistics (daily observations).
Joint
4.847* 10.311** 0.490 0.162 0.120 5.760* 2.533 0.205 277.940** 88.317**
lags Wald
F
0.991 12.623** 0.006 0.066 0.210 3.689 1.544 1.602 355.372** 99.320**
0.940 12.000** 0.007 0.056 0.196 3.497 1.464 1.520 337.375’** 94.260**
for pairs of
Ten-period Joint
F
lags Wald
1.896 10.420** 0.005 0.405 0.790 4.274* 2.822 2.706 337.853** 85.745**
2.100 11.480** 0.006 0.448 0.875 4.731* 3.123 2.990 373.248** 94.817**
* Significant at 5 per cent. ** Significant at 1 per cent.
TABLE 3. Direct
and reverse causality-two-year restricted and unrestricted equations One-period
Years
Joint
F
1974-75 1976-77 1978-79 1980-81 1982-83
2.826 8.311** 9.188** 31.770** 2.452
Five-period
lag Wald Direct:
Joint
2.638 3.302 0.566 5.403* 44.136**
lags Wald
F
ES as the dependent
2.843 8.366** 9.248** 31 969** 2:466 Reverse:
1974-75 1976-77 1978-79 1980-81 1982-83
periods. Test statistics (daily observations).
2.827 12.503** 0.593 5.437* 44.414**
15.413** 14.430** 52.897** 92.952** 0.483
Ten-period Joint
F
of
lags Wald
variable 78.891** 73.858”* 270.742** 425.709** 2.474
CD as the dependent 2.341* 0.401 2.192* 2.940** 16.152**
for pairs
8.951** 7.371** 25.996** 51.452** 0.763
93.689** 77.152** 272.094** 538.964** 7.979
1.556 0.391 2.209* 1.824* 10.189**
16.486 7.912 23.584** 19.092* 106.623**
variable 13.774* 6.536 14.443* 15.045* 82.662**
* Significant at 5 per cent. T* Significant at 1 per cent.
1. For weekly data, 1974 shows the strongest causality, both direct and reverse (Table 5). Minimal relationships are indicated for the remaining years. The major difference between daily and weekly data results is obvious from a comparison of contemporaneous effects shown in Table 6 (weekly) and Table 2 (daily). Weekly data reveal extremely strong contemporaneous determination for Table
221
PEGGY E. SWANSON TABLE 4. Contemporaneous determination-two-year restricted and unrestricted equations One-period Years 1974-75 1976-77 1978-79 1980-81 1982-83
Joint
F
Five-period
lag
Joint
W’ald 9.821** 0.714 6.519* 0.188 476.144**
9.740** 0.710 6.465** 0.187 472.186**
periods. Test statistics (daily observations). lags
Ten-period
Wald
F
F
Joint
4.814* 0.000 3.028* 0.292 603.091**
4.693* 0.000 4.898* 0.285 587.947**
for pairs of
lags Wald 6.962** 0.006 7.660** 0.601 620.444**
6.636** 0.009 7.302** 0.574 591.594**
* Significant at 5 per cent. ** Significant at 1 per cent.
TABLE 5. Direct and reverse causality-one-year restricted and unrestricted equations One-period Year
Joint
F
lag Wald Direct:
1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
8.914** 1.368 1.803 0.784 2.414 0.540 0.040 0.163 0.060 0.042
9.483* 1.455 1.919 0.832 2.568 0.574 0.042 0.173 0.059 0.045 Reverse:
1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
1.942 0.082 0.740 1.264 4.261* 0.237 3.559 0.987 2.282 5.576*
* Significant at 5 per cent. at 1 per cent.
** Significant
2.066 0.087 0.503 1.350 4.530 0.252 3.787 1.050 2.428 5.932
periods. (weekly
Two-period Joint
F
EJ6as the dependent 4.124* 2.518 0.910 2.013 0.853 0.185 0.515 0.099 0.109 0.760 CD as the dependent 5.455** 0.299 1.569 0.768 4.577* 0.761 2.105 0.695 0.811 3.199*
Test statistics observations).
lags W’ald
for pairs
Four-period Joint
F
of
lags Bald
variable 9.185 5.607 2.027 4.478 1.899 0.411 1.147 0.220 0.242 1.692
5.499** 2.049 1.558 3.923** 0.947 1.378 1.199 0.157 0.351 0.702
27.203** 10.139 7.708 19.412* 4.686 6.819 5.930 0.778 1.734 3.474
2.747’ 0.638 0.405 0.697 2.527 0.768 1.713 0.877 1.582 1.341
13.590 3.155 2.004 3.433 12.498 3.800 8.476 4.338 7.826 6.634
variable 12.151* 0.666 3.487 1.708 10.193 1.695 4.688 1.548 1.806 7.124
222
Capitd
.\lark:et
Integration
owr th
Past
Drcah
every year escept 1974. Daily data reveal contemporaneous determination for 1975, 1982, and 1983 only. Weekly data show 1974 to have the weakest effect; for all other years, the test statistics are significant at 0.01. The implications are clarified further by Table 7 when the periods are of twoyear lengths. Weekly observations show that 1974-75 esperienced strong direct causality but no significant reverse causality. For daily observations (Table 3), 1974-75 revealed weaker direct causality but slight feedback effects. While reverse causality became highly significant for 1982-83 with daily data, the impact is minimal for weekly data. Table 8, which provides the results of tests for contemporaneous determination using weekly observations, explains these opposing results. With daily data, the observation period is so short that impacts are reflected through causality rather than contemporaneous adjustment. With weekly data, the adjustment is consistently significantly contemporaneous.
III.
Conclusions
This study has investigated changing capital market integration over the decade 1973-83 as measured by the relationship between Eurodollar and domestic US dollar yields. Granger techniques were used to study direct causality, feedback effects, and contemporaneous determination for the two yield series. Both daily and weekly observations were used to test one-year and two-year periods. Evidence is strong that the degree of integration is increasing throughout the period. Direct causality is stronger than reverse causality, but contemporaneous determination dominates when the length of the observation period is one week. This implies highly rapid responses of both the US market and the Euromarket to changes in returns in the other market. These results make obvious the importance of the length of the observation period. Other studies generally have used longer periods, monthly or quarterly;
TABLE 6. Contemporaneous
determination -one-year periods. Test statistics for pairs of restricted and unrestricted equations (weekly observations). One-period
lag
Two-period
lags
Four-period
lags
Year
Joint F
Wald
Joint F
Wald
Joint F
Yi’ald
1974
11.023** 49.360** 12.993** 37.112** 90.476** 157.472** 272.308** 420.716** 359.285** 107.383*”
11.982* 53.652** 14.122** 40.343** 9a.345** 171.168** 295.985** 457.297** 390.528** 116.713**
10.404** 60.682** 50.855** 48.245** 84.525** 173.969** 344.621** 483.637** 330.710** 126.759**
11.855 69.149** 57.592** 54.979** 96.314** 198.243** 392.705** 551.128** 376.845** 144.437**
4.934” -19.186*’ 54.522” 33.017” 111.365”” 198.743”’ 310.738”” 565.986” 321.880” 112.704”
6.266 62.481** 69.256** 41.936** 141.459** l-2.426** 394.719** :18.947** 108.8’1** 1-43.17-l**
1975 1976 1977 1978 1979 1980 1981 1982 1983
* Significant at 5 per cent. ** Significant at 1 per cent.
PEGGY
TABLE 7. Direct and reverse causality-two-year restricted and unrestricted equations One-period Years
Joint
Direct:
1974-75 1976-77 1978-79 1980-81 1982-83
Joint
Wald
F
F
E$ as the dependent
9.777* 3.846 1.448 0.309 0.063
9.489** 3.734* 1.406 0.683 0.061
periods.
7.455** 1.790 0.360 0.778 0.276
Reverse: CD as the dependent 1974-75 1976-77 1978-79 1980-81 1982-83
0.230 0.171 1.489 5.383* 6.213**
0.237 0.176 1.534 5.537 6.401
Test
statistics
for pairs
of
(weekly observations).
Two-period
lag
223
E. SWANSON
2.706 1.662 2.625 3.808* 2.506
lags Wald
Four-period Joint
F
lags Wald
variable 15.686** 3.767 0.758 0.880 0.581
6.256** 1.776 2.026 1.517 0.689
2-.525** 7.814 8.916 6.579 3.030
1.616 0.326 2.144 2.484* 3.482**
7.111 1.431 9.433 13.582 15.319
variable 5.694 3.500 5.523 9.163 5.273
* Significant at 5 per cent. ** Significant at 1 per cent.
TABLE 8. Contemporaneous determination -two-year periods. Test statistics restricted and unrestricted equations (weekly observations). One-period Years 1974-75
1976-77 1978-79 1980-81 1982-83 * Significant ** Significant
Joint
F
64.336** 34.130** 298.831** 714.952** 608.356**
lag Wald
66.962** 35.524** 311.028** 697.506** 633.177**
Two-period
lags
F
Wald
Joint
73.100** 91.788** 324.209** 864.590** 590.854**
77.714** 86.790** 344.690** 821.026” 628.182**
Four-period Joint
F
64.204** 88.345** 359.458** 956.193** 587.181**
for pairs of
lags Wald
71.417** 98.270** 399.848** 950.040** 653.142**
at 5 per cent. at 1 per cent.
however, this study indicates that shorter periods are more appropriate and that the findings will be strongly affected by the choice of observation period. When determining monetary policy actions, the existence of direct causality and/or feedback effects requires different behavior than if the yields are contemporaneously determined. If the response to changes in returns is delayed, policy makers have a chance to undertake offsetting measures if the impacts are undesirable, providing at least some degree of temporary isolation for the domestic market. If the impacts are almost immediate, that opportunity is lost. This study indicates that, if any isolation exists, it begins to be eroded within one day.
Capital
224
hlarket
Integration
ouer the Part Decade
Many events would be expected to impact the Eurodollar-CD relationship. The removal of barriers by the USA to capital outflows in 1974 are probably reflected in alone should appreciably decrease the the 1975 outcome. These changes isolationism of the US capital market. Various regulatory changes, especially as they related to res=rve requirements on CDs, on Eurodollar deposits, and on foreign borrowings, occurred throughout the period. The overall effect of the changes is not clear because they sometimes encouraged and sometimes discouraged capital market segmentation. Impacts of the Depository Institution Deregulation and Monetary Control Act of 1980 probably have contributed to recent increases in integration. The strongest changes, which occurred in 1982, may be reflecting market responses to increased variability of interest rates and increased risk. Especially noteworthy are such events as the beginning of trading in Eurodollar futures in December of 1981, the evolution of a short-term interest rate swap market, and increased use and sophistication of electronic information systems. The overall results suggest that opportunities for profitable arbitrage exist. are probably illusory. The issue of transactions These opportunities, however, costs and capital controls/restrictions have not been explicitly addressed. Kreicher (1982) defined an arbitrage tunnel applicable to bank activities where differential reserve requirements and FDIC insurance prevent perfect arbitrage. He also cited financial statement constraints as impacting bank behavior. While the non-banking sector does not face these same issues, its arbitrage activities are of much smaller magnitude. Interestingly, Kaen et al. (1983) found no arbitrage opportunities when financial futures contract prices were considered. While other studies also have found important causality effects, the strong contemporaneous adjustment found on a daily basis after 1981 in this study may indicate the importance of such developments as Eurodollar futures in the arbitrage process. Based on Eurodollar deposit and Certificate of Deposit yields, this study indicates that capital market integration has increased over the past decade and that significant contemporaneous impacts exist. The strong finding of recent feedback effects within one day suggests that the USA is limited in its ability to control the US economy. Further and more detailed study is necessary to explicitly incorporate adjustments, such as capital controls, central bank regulations, risk, etc., which must be made to achieve precise comparability of yields for measuring capital market integration.
Notes example, Granger (1969). Feige and Pearce (1979), Geweke et al. (1979). and Kaen and Hachey (1983). 2. The Wald test is described by Geweke et al. (1?79) and was used in the Kaen and Hachey (1983) 1. See, for
study. 3. For a good
description
of the arbitrage
activities,
see Kreicher
(1982).
References FEIGE, E.L., ASD D.K. Caveats for Time 533.
PEARCE, ‘The Casual Causal Relationship Between Money and Income: Some 1979, 61: 521Series hnalysis,’ R&IV of Economics and Statistics, November
PEGGY
E. SWASSON
225
GEWEKE. J,, R. MEESE, AND W.T. DENT, Comparing Alternative Testrof Causali~ in TemporalSystrms: Research Institute, University of .-Ina~tic Rerultr and Experimental hidencr, Social Systems Wisconsin-Plladison, October 1979. GIDDY, I.H., G. DUFEY, AND S. MN, ‘Interest Rates in the U.S. and Eurodollar Markets,’ Weltwirtscbafrlicbcs A&iv, 1979, 115: 5 1-67. GRANCER, C.W.J., ‘Investigating Causal Relations by Econometric Models and Cross-Spectral blethods,’ Econometrica, July 1969, 37: 424-438. HARTXIAN, D.G., ‘The International Financial Market and U.S. Interest Rates,‘Jorrmnalof International Mone_yand Finance, April 1984, 3: 91-103. HENDERSHOTT, P.H., ‘The Structure of International’Interest Rates: The U.S. Treasury Bill Rate and the Eurodollar Deposit Rate,’ Journal of Finance, September 1967, 22: 455-465. KAEN, F.R., AND G.A. HACHEY, ‘Eurocurrency and National Money Market Interest Rates: An Empirical Investigation of Causality,‘JournalofMong, Credit and Banking, August 1983,lS: 327338. KAEN, F.R., B.P. HELMS, AND G.G. BOOTH, ‘The Integration of Eurodollar and U.S. Money Market Interest Rates in the Futures Market,’ Weltwirtscbaftlicber Arc&v, 1983, 119: 601-615. KREICHER, L.L., ‘Eurodollar Arbitrage,’ Federal Reserve Bank ofNew YorkQuarterb Review, Summer 1982, 7: 10-22. KWACK, S.Y., ‘The Structure of International Interest Rates: An Extension of Hendershott’s Tests,’ Journal of Finance, September 1971, 26: 897-900.
Capital Market Integration over the Past Decade: The Case of the US Dollar PEGGY E. SWANSOS Department of Finance, University of Texas at Arlington, USA
Arlington,
TX
760 19,
This study investigates changing capital market integration over the decade 1973-83 as measured by the relationship between Eurodollar and domestic US dollar yields. The findings reveal that capital market
integration
has increased appreciably
since the end of 1981.
Evidence has been mounting that world capital markets are becoming increasingly integrated. Although closer relationships among the world’s capital markets result in a higher level of efficiency on a global scale, the reduction in capital market segmentation diminishes the ability of governments to achieve independent economic policies. In the past, the United States, together with much of the rest of the world, generally considered the US market to be sufficiently isolated or dominant that independent policies could be effectively pursued. This assumption Numerous studies have investigated the is becoming highly questionable. independence of the US market, but diverse approaches, different statistical techniques, and noncomparable data, either by type or period covered, have prevented a determination of changes in the degree of capital market integration over time. This study investigates changes in the relationship between US dollar returns in the United States and in external dollar markets, on a yearly and biyearly basis, over the period 1973-83, inclusive. Before the existence of the Eurocurrency markets, studies analyzing capital market integration were hampered by differing national money market regulations and constraints and by problems related to foreign exchange rate impacts on different currency denominated asset yields. Despite these problems, responsiveness of short-term capital flows to interest-rate differentials (and changes in the differentials) indicated some degree of capital market integration. Virtually all work, however, assumed or found that the US money market was relatively isolated from external money market events. The development of offshore markets, which has allowed more efficient testing, appears to have decreased US independence, but only recently has the effect been studied explicitly. Early works have been criticized in two aspects. First, they investigated one-way causality only-from the US dollar market to the Eurodollar market, and feedback 0261-5606/87/02/021S-11503.000 1987 Butterworth & Co (Publishers) Lrd
216
Capital
Market
Integration ot’er the Past Decade
effects were ignored. Second, the US rate of return had to be measured by some less than ideal proxy, usually the US Treasury Bill rate. No comparable deposit rate for Eurodollar deposits existed in the USA prior to 1973 when interest rate ceilings began to be removed. Hendershott’s original contribution (1967) concluded that, for the period 195764, the Eurodollar rate adjusted completely to changes in the US Treasury Bill rate, but the required adjustment period was roughly one year; the first month’s impact was approximately 20 per cent of the total. However, applying Hendershott’s estimated adjustment coefficients, 95 per cent adjustment required 22 months using monthly data and seven quarters using quarterly data. Kwack’s (1971) study estended Hendershott’s work by considering foreign rates. Using Hendershott’s formulation and assuming that foreign rates remain constant, Kwack found that, for the period 1960111-67IV, three quarters were necessary to achieve 95 per cent of the Eurodollar adjustment to US Treasury Bill rate changes. When foreign rates were allowed to vary, Kwack found less than full adjustment. Thus, identical techniques and measurements revealed more rapid adjustment of offshore dollar markets to changes in US market yields during the 1960-67 period than during the 1957-64 period. Unfortunately, later studies are not directly comparable. Giddy et al. (1979) were among the first to substitute Certificate of Deposit rates for Treasury Bill rates as the appropriate measure of US returns to compare to Eurodollar deposit rates. Another break from earlier studies was their attempt to show that the Eurodollar market was an integral part of the total dollar market and not merely a market determined by US rates. Thus introducing the idea of feedback effects, they concluded that the US market, because of domestic regulations and constraints, was less flexible than the Eurodollar market and responded more slowly to external changes than the Eurodollar market. Several recent studies of the interest-rate transmission mechanism have explicitly investigated the strength of feedback effects to the US market. Kaen and Hachey (1983), using Granger causality tests, found, for the period 1974-81 and based on three measures of US returns-US Treasury Bills, commercial paper, and Certificates of Deposit -that the domestic dollar market responds more quickly to changing conditions in the Euromarkets than conversely. This finding disagrees with that of Giddy et al. Hartman (1984), comparing a 1971-74 period to a 1975-78 period, found no significant impacts of external forces on the US market during the early period but highly significant impacts during the latter period. He thus concluded that feedback effects were a recent phenomenon.
I. Methodology Granger causality tests are selected for determining the degree and direction of causality between the US money market and the external dollar market. The advantages of these as opposed to other available tests have been shown.’ By including past, present, or future values of a variable, the approach allows one to determine whether or not forecast errors can be reduced for that variable. Thus direct causality, reverse causality, and contemporaneous adjustments can be studied for any two money market rate series. Classical ordinary least squares estimates may be biased as a result of the inclusion of lagged dependent variables as independent variables in the regression
PEGGY
217
E. SWASSON
equations. Thus, standard tests of statistical significance may not be applicable. If serial correlation of the error term or correlation between the lagged dependent variables and the error term is a problem, Wald’s test’ will provide the necessary test statistic. For ease of testing if these problems occur, the Granger test is formulated on the basis of restricted and unrestricted equations. The restricted equation contains only lagged values of the dependent variable; the unrestricted equation contains lagged values of both the dependent variable and the second series of yields. The two series tested are 3-month yields as measured by US Certificates of Eurodollar deposit rates, ES, and by yields on negotiable Deposit, CD. Defining all variables as first differences, the equations can be written as:
ES, = a +
(2)
ES, = a +
c
b,(B),_, +e,
E b,(a),_, + IX 4(CD>,-, +e, ,=I
i=l
(3)
CD, = a+ 5 b,(CD),_; +e, CD, = a + C b;(CD),_, + i=l
x 4(E$>,_;+e, i=l
where n identifies the number of lags. Equations (1) and (2) test for causality from the US domestic market to the external market; equations (3) and (4) test for reverse causality. If the direction of impact is that given in (1) and (2), some of the coefficients of the CD terms in (2) should be significantly different from zero; (3) and (4) describe the opposite directionality, and some of the dj terms in (4) should be significantly different from zero if feedback effects exist. If all d, are zero (in both equations (2) and (4)), the two interest-rate series are independent or contemporaneously determined. To test for contemporaneous determination, equations (2) and (4) are reestimated with current values of CD and ES, respectively, included as independent variables. II. Tests for Direct Causality,
Reverse Causality, Determination
and Contemporaneous
If capital market integration is increasing, a more rapid speed of adjustment requires shorter observation periods. Thus the basic data set is comprised of daily observations of 3-month maturity yields on Eurodollar deposits and on negotiable Certificates of Deposit during the period January 1, 1973 through December 31, 1983. Three-month maturities are selected because of the large volume of transactions in both markets at this maturity. The depth and breadth of these markets facilitate arbitrage activities. a Changes in the transmission mechanism are investigated by dividing the basic data set into ten one-year and five two-year data sets. Unexpectedly large responses in the two markets to daily changes in yields suggested that the same tests be conducted for verification purposes with weekly observations. The weekly observations used are the last day of the week values rather than averages for the week.
218
Capital Alarket Integrationowr tbc Past Decade
Before equations (l>-(4) can be tested using the various data sets of daily observations, one slight modification must be made because Eurodollar and CD deposit rates are not quoted identically. In the Eurodollar market, prior to October 1981, delivery for deposits occurred two business days after the transaction resulting in quoted rates in the offshore market actually being available two days after the quote. CD rates, however, are available on the day of the quote. Therefore, to be comparable, CD, must be paired with ES,_* during most of the period. For the remainder of the period, CD, is comparable to ES,. The lags selected for testing the daily data sets are one, five, and ten days. Five-day lags approximate weekly effects and ten-day lags approximate semimonthly effects. Although these periods are not long enough to expect completion of the adjustment process, they should be adequate to detect direction of causality. The longer the period considered, the greater the probability that influences other than changes in yields are affecting the results. Fortunately, the tests are not highly sensitive to the number of lags for data sets which have not been prefiltered (Kaen and Hachey, p. 331). For the weekly data sets, CD, is the appropriate counterpart of E$, and equations (l)-(4) are tested as presented above. The lags chosen are one, two, and four weeks. Again, longer periods are avoided because of the unidentifiable estraneous influences in the two yield series. Initial tests provided only slight indications of biased estimates. Later tests revealed somewhat stronger problems. Thus, for consistency, both the Joint Fand Wald test statistics are reported throughout. The first series of tests use the daily observation periods. Table 1 sets forth the test. statistics for direct and reverse causality for one-, five-, and ten-period lags. Until 1982, strong impacts of changes in CD yields on changes in Eurodollar yields is evident from the equations using Eurodollar returns (E$) as the dependent variable. Evidence of feedback effects (or reverse causality), shown by the equations using Certificate of Deposit yields (CD) as the dependent variable, is weaker but gaining strength over time. With a one-day lag, the direct impacts are significant at 0.01 for 1977 and 1980 only. These years were basically characterized by ample liquidity in international capital markets, generally falling or volatile interest rates, and unstable foreign exchange markets. The first two events would be expected to further capital market integration because of increased competition among both demanders and suppliers of funds; the impact of volatile exchange rates is less clear. No direct causality is indicated for the last two years. Reverse causality, on the other hand, is highly significant for 1982 and 1983. Table 2 sets forth the test results for contemporaneous determination; that is, current values of the independent variable are included in equations (2) and (4). Thus, the Joint F and the Wald test statistics are measuring statistical significance of differences between pairs of equations where one equation does and one equation does not contain current values of an independent variable. If the adjustment is contemporaneous+ a significant improvement in SSE should occur when the current value of the .independent variable is added to the regression equation. Because simultaneous determination yields identical test statistics when ES and CD are the dependent variables, the values are each only reported once. Little evidence exists of contemporaneous adjustment during the early years except for 1975 which appears to be unique. The severe recession in major industrial countries, the relaxation of US monetary restraint, and the fall of
219
PEGGY E. SW.~SSOS TABLE 1. Direct and reverse causality-one-year periods. Test statistics restricted and unrestricted equations (daily observations). One-period Year
Wald
E$ as the dependent
0.528 2.234 0.441 12.318** 3.424 4.565* 75.346** 0.550 1.592 0.015
0.522 2.204 0.440 12.159** 3.381 4.507* 74.392** 0.543 1.571 0.102
lags
Joint F
Wald
Joint F
Direct: 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
Five-period
lag
8.467** 5.724* * 7.306** 13.064** 10.161** 36.599** 54.272** 40.744** 0.450 0.353
2.743 0.002 0.857 5.023* 0.035 0.984 0.727 5.573* 18.285** 39.167**
5.447* 1.443 0.871 5.993* 0.145 1.214 0.894 5.644* 18.517** 39.711**
2.421* 0.184 0.443 1.003 0.188 2.156 1.338 2.330* 6.637** 14.414**
Ten-period Joint F
lags K’ald
variable -!4.430** 29.978** 38.342** 68.557** 53.318** 192.062** 284.803** 213.637** 2.357 1.859
Reverse: CD as the dependent 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
for pairs of
4.812** 3.727** 3.589** 6.930* * 6.195** 17.171** 28.848** 21.916** 0.470 0.649
53.004**
41.054** 39.530*” -6.328** 68.237** 189.127** 317.751** 2-10.973** 5.172 7.138
variable 13.319* 3.153 3.599 6.032 2.028 12.374* 7.209 12.216* 34.801** 75.613**
1.492 0.765 0.408 1.016 0.783 2.009* 2.073* 1.794 4.096** 9.851**
16.878 8.750 A.678 11.690 11.413 23.453*’ X.838* 19.719* -L&.740** 108.406**
* Significant at 5 per cent. ** Significant at 1 per cent.
Eurodollar rates to their 1972 level may partially esplain these results. The last two years, however, reflect strong contemporaneous determination. In order to better estimate market changes, Tables 3 and 4 report the results of tests for direct and reverse causality and for contemporaneous determination, respectively, over two-year periods. Daily observations still comprise the data sets. The longer time periods provide stronger indications of direct causality until 1982 (Table 3) and increasing feedback effects are reflected by all three lag measures. Based on the Wald test, contemporaneous determination is sporadic (Table 4). The strong indications of direct causality indicated by five- and ten-period lags using daily data (Tables 1 and 3) suggest that much of the adjustment in Eurodollar rates occurs within one or two weeks after a change in US rates. For this reason, the tests are repeated using weekly observations. The lags tested are one, two, and four periods. Thus the longest lags include roughly monthly impacts. Table 5 sets forth the direct and reverse causality results for weekly observations. The findings are very different from those with daily observations as shown in
220 TABLE
Capital iClarket Integration over the Past Decade 2. Contemporaneous determination-one-year restricted and unrestricted equations One-period
Year 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
Joint
F
Five-period
lag Wald
4.765* 10.145** 0.480 0.162 0.119 5.664* 2.490 0.202 273.324** 86.695**
periods. Test statistics (daily observations).
Joint
4.847* 10.311** 0.490 0.162 0.120 5.760* 2.533 0.205 277.940** 88.317**
lags Wald
F
0.991 12.623** 0.006 0.066 0.210 3.689 1.544 1.602 355.372** 99.320**
0.940 12.000** 0.007 0.056 0.196 3.497 1.464 1.520 337.375’** 94.260**
for pairs of
Ten-period Joint
F
lags Wald
1.896 10.420** 0.005 0.405 0.790 4.274* 2.822 2.706 337.853** 85.745**
2.100 11.480** 0.006 0.448 0.875 4.731* 3.123 2.990 373.248** 94.817**
* Significant at 5 per cent. ** Significant at 1 per cent.
TABLE 3. Direct
and reverse causality-two-year restricted and unrestricted equations One-period
Years
Joint
F
1974-75 1976-77 1978-79 1980-81 1982-83
2.826 8.311** 9.188** 31.770** 2.452
Five-period
lag Wald Direct:
Joint
2.638 3.302 0.566 5.403* 44.136**
lags Wald
F
ES as the dependent
2.843 8.366** 9.248** 31 969** 2:466 Reverse:
1974-75 1976-77 1978-79 1980-81 1982-83
periods. Test statistics (daily observations).
2.827 12.503** 0.593 5.437* 44.414**
15.413** 14.430** 52.897** 92.952** 0.483
Ten-period Joint
F
of
lags Wald
variable 78.891** 73.858”* 270.742** 425.709** 2.474
CD as the dependent 2.341* 0.401 2.192* 2.940** 16.152**
for pairs
8.951** 7.371** 25.996** 51.452** 0.763
93.689** 77.152** 272.094** 538.964** 7.979
1.556 0.391 2.209* 1.824* 10.189**
16.486 7.912 23.584** 19.092* 106.623**
variable 13.774* 6.536 14.443* 15.045* 82.662**
* Significant at 5 per cent. T* Significant at 1 per cent.
1. For weekly data, 1974 shows the strongest causality, both direct and reverse (Table 5). Minimal relationships are indicated for the remaining years. The major difference between daily and weekly data results is obvious from a comparison of contemporaneous effects shown in Table 6 (weekly) and Table 2 (daily). Weekly data reveal extremely strong contemporaneous determination for Table
221
PEGGY E. SWANSON TABLE 4. Contemporaneous determination-two-year restricted and unrestricted equations One-period Years 1974-75 1976-77 1978-79 1980-81 1982-83
Joint
F
Five-period
lag
Joint
W’ald 9.821** 0.714 6.519* 0.188 476.144**
9.740** 0.710 6.465** 0.187 472.186**
periods. Test statistics (daily observations). lags
Ten-period
Wald
F
F
Joint
4.814* 0.000 3.028* 0.292 603.091**
4.693* 0.000 4.898* 0.285 587.947**
for pairs of
lags Wald 6.962** 0.006 7.660** 0.601 620.444**
6.636** 0.009 7.302** 0.574 591.594**
* Significant at 5 per cent. ** Significant at 1 per cent.
TABLE 5. Direct and reverse causality-one-year restricted and unrestricted equations One-period Year
Joint
F
lag Wald Direct:
1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
8.914** 1.368 1.803 0.784 2.414 0.540 0.040 0.163 0.060 0.042
9.483* 1.455 1.919 0.832 2.568 0.574 0.042 0.173 0.059 0.045 Reverse:
1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
1.942 0.082 0.740 1.264 4.261* 0.237 3.559 0.987 2.282 5.576*
* Significant at 5 per cent. at 1 per cent.
** Significant
2.066 0.087 0.503 1.350 4.530 0.252 3.787 1.050 2.428 5.932
periods. (weekly
Two-period Joint
F
EJ6as the dependent 4.124* 2.518 0.910 2.013 0.853 0.185 0.515 0.099 0.109 0.760 CD as the dependent 5.455** 0.299 1.569 0.768 4.577* 0.761 2.105 0.695 0.811 3.199*
Test statistics observations).
lags W’ald
for pairs
Four-period Joint
F
of
lags Bald
variable 9.185 5.607 2.027 4.478 1.899 0.411 1.147 0.220 0.242 1.692
5.499** 2.049 1.558 3.923** 0.947 1.378 1.199 0.157 0.351 0.702
27.203** 10.139 7.708 19.412* 4.686 6.819 5.930 0.778 1.734 3.474
2.747’ 0.638 0.405 0.697 2.527 0.768 1.713 0.877 1.582 1.341
13.590 3.155 2.004 3.433 12.498 3.800 8.476 4.338 7.826 6.634
variable 12.151* 0.666 3.487 1.708 10.193 1.695 4.688 1.548 1.806 7.124
222
Capitd
.\lark:et
Integration
owr th
Past
Drcah
every year escept 1974. Daily data reveal contemporaneous determination for 1975, 1982, and 1983 only. Weekly data show 1974 to have the weakest effect; for all other years, the test statistics are significant at 0.01. The implications are clarified further by Table 7 when the periods are of twoyear lengths. Weekly observations show that 1974-75 esperienced strong direct causality but no significant reverse causality. For daily observations (Table 3), 1974-75 revealed weaker direct causality but slight feedback effects. While reverse causality became highly significant for 1982-83 with daily data, the impact is minimal for weekly data. Table 8, which provides the results of tests for contemporaneous determination using weekly observations, explains these opposing results. With daily data, the observation period is so short that impacts are reflected through causality rather than contemporaneous adjustment. With weekly data, the adjustment is consistently significantly contemporaneous.
III.
Conclusions
This study has investigated changing capital market integration over the decade 1973-83 as measured by the relationship between Eurodollar and domestic US dollar yields. Granger techniques were used to study direct causality, feedback effects, and contemporaneous determination for the two yield series. Both daily and weekly observations were used to test one-year and two-year periods. Evidence is strong that the degree of integration is increasing throughout the period. Direct causality is stronger than reverse causality, but contemporaneous determination dominates when the length of the observation period is one week. This implies highly rapid responses of both the US market and the Euromarket to changes in returns in the other market. These results make obvious the importance of the length of the observation period. Other studies generally have used longer periods, monthly or quarterly;
TABLE 6. Contemporaneous
determination -one-year periods. Test statistics for pairs of restricted and unrestricted equations (weekly observations). One-period
lag
Two-period
lags
Four-period
lags
Year
Joint F
Wald
Joint F
Wald
Joint F
Yi’ald
1974
11.023** 49.360** 12.993** 37.112** 90.476** 157.472** 272.308** 420.716** 359.285** 107.383*”
11.982* 53.652** 14.122** 40.343** 9a.345** 171.168** 295.985** 457.297** 390.528** 116.713**
10.404** 60.682** 50.855** 48.245** 84.525** 173.969** 344.621** 483.637** 330.710** 126.759**
11.855 69.149** 57.592** 54.979** 96.314** 198.243** 392.705** 551.128** 376.845** 144.437**
4.934” -19.186*’ 54.522” 33.017” 111.365”” 198.743”’ 310.738”” 565.986” 321.880” 112.704”
6.266 62.481** 69.256** 41.936** 141.459** l-2.426** 394.719** :18.947** 108.8’1** 1-43.17-l**
1975 1976 1977 1978 1979 1980 1981 1982 1983
* Significant at 5 per cent. ** Significant at 1 per cent.
PEGGY
TABLE 7. Direct and reverse causality-two-year restricted and unrestricted equations One-period Years
Joint
Direct:
1974-75 1976-77 1978-79 1980-81 1982-83
Joint
Wald
F
F
E$ as the dependent
9.777* 3.846 1.448 0.309 0.063
9.489** 3.734* 1.406 0.683 0.061
periods.
7.455** 1.790 0.360 0.778 0.276
Reverse: CD as the dependent 1974-75 1976-77 1978-79 1980-81 1982-83
0.230 0.171 1.489 5.383* 6.213**
0.237 0.176 1.534 5.537 6.401
Test
statistics
for pairs
of
(weekly observations).
Two-period
lag
223
E. SWANSON
2.706 1.662 2.625 3.808* 2.506
lags Wald
Four-period Joint
F
lags Wald
variable 15.686** 3.767 0.758 0.880 0.581
6.256** 1.776 2.026 1.517 0.689
2-.525** 7.814 8.916 6.579 3.030
1.616 0.326 2.144 2.484* 3.482**
7.111 1.431 9.433 13.582 15.319
variable 5.694 3.500 5.523 9.163 5.273
* Significant at 5 per cent. ** Significant at 1 per cent.
TABLE 8. Contemporaneous determination -two-year periods. Test statistics restricted and unrestricted equations (weekly observations). One-period Years 1974-75
1976-77 1978-79 1980-81 1982-83 * Significant ** Significant
Joint
F
64.336** 34.130** 298.831** 714.952** 608.356**
lag Wald
66.962** 35.524** 311.028** 697.506** 633.177**
Two-period
lags
F
Wald
Joint
73.100** 91.788** 324.209** 864.590** 590.854**
77.714** 86.790** 344.690** 821.026” 628.182**
Four-period Joint
F
64.204** 88.345** 359.458** 956.193** 587.181**
for pairs of
lags Wald
71.417** 98.270** 399.848** 950.040** 653.142**
at 5 per cent. at 1 per cent.
however, this study indicates that shorter periods are more appropriate and that the findings will be strongly affected by the choice of observation period. When determining monetary policy actions, the existence of direct causality and/or feedback effects requires different behavior than if the yields are contemporaneously determined. If the response to changes in returns is delayed, policy makers have a chance to undertake offsetting measures if the impacts are undesirable, providing at least some degree of temporary isolation for the domestic market. If the impacts are almost immediate, that opportunity is lost. This study indicates that, if any isolation exists, it begins to be eroded within one day.
Capital
224
hlarket
Integration
ouer the Part Decade
Many events would be expected to impact the Eurodollar-CD relationship. The removal of barriers by the USA to capital outflows in 1974 are probably reflected in alone should appreciably decrease the the 1975 outcome. These changes isolationism of the US capital market. Various regulatory changes, especially as they related to res=rve requirements on CDs, on Eurodollar deposits, and on foreign borrowings, occurred throughout the period. The overall effect of the changes is not clear because they sometimes encouraged and sometimes discouraged capital market segmentation. Impacts of the Depository Institution Deregulation and Monetary Control Act of 1980 probably have contributed to recent increases in integration. The strongest changes, which occurred in 1982, may be reflecting market responses to increased variability of interest rates and increased risk. Especially noteworthy are such events as the beginning of trading in Eurodollar futures in December of 1981, the evolution of a short-term interest rate swap market, and increased use and sophistication of electronic information systems. The overall results suggest that opportunities for profitable arbitrage exist. are probably illusory. The issue of transactions These opportunities, however, costs and capital controls/restrictions have not been explicitly addressed. Kreicher (1982) defined an arbitrage tunnel applicable to bank activities where differential reserve requirements and FDIC insurance prevent perfect arbitrage. He also cited financial statement constraints as impacting bank behavior. While the non-banking sector does not face these same issues, its arbitrage activities are of much smaller magnitude. Interestingly, Kaen et al. (1983) found no arbitrage opportunities when financial futures contract prices were considered. While other studies also have found important causality effects, the strong contemporaneous adjustment found on a daily basis after 1981 in this study may indicate the importance of such developments as Eurodollar futures in the arbitrage process. Based on Eurodollar deposit and Certificate of Deposit yields, this study indicates that capital market integration has increased over the past decade and that significant contemporaneous impacts exist. The strong finding of recent feedback effects within one day suggests that the USA is limited in its ability to control the US economy. Further and more detailed study is necessary to explicitly incorporate adjustments, such as capital controls, central bank regulations, risk, etc., which must be made to achieve precise comparability of yields for measuring capital market integration.
Notes example, Granger (1969). Feige and Pearce (1979), Geweke et al. (1979). and Kaen and Hachey (1983). 2. The Wald test is described by Geweke et al. (1?79) and was used in the Kaen and Hachey (1983) 1. See, for
study. 3. For a good
description
of the arbitrage
activities,
see Kreicher
(1982).
References FEIGE, E.L., ASD D.K. Caveats for Time 533.
PEARCE, ‘The Casual Causal Relationship Between Money and Income: Some 1979, 61: 521Series hnalysis,’ R&IV of Economics and Statistics, November
PEGGY
E. SWASSON
225
GEWEKE. J,, R. MEESE, AND W.T. DENT, Comparing Alternative Testrof Causali~ in TemporalSystrms: Research Institute, University of .-Ina~tic Rerultr and Experimental hidencr, Social Systems Wisconsin-Plladison, October 1979. GIDDY, I.H., G. DUFEY, AND S. MN, ‘Interest Rates in the U.S. and Eurodollar Markets,’ Weltwirtscbafrlicbcs A&iv, 1979, 115: 5 1-67. GRANCER, C.W.J., ‘Investigating Causal Relations by Econometric Models and Cross-Spectral blethods,’ Econometrica, July 1969, 37: 424-438. HARTXIAN, D.G., ‘The International Financial Market and U.S. Interest Rates,‘Jorrmnalof International Mone_yand Finance, April 1984, 3: 91-103. HENDERSHOTT, P.H., ‘The Structure of International’Interest Rates: The U.S. Treasury Bill Rate and the Eurodollar Deposit Rate,’ Journal of Finance, September 1967, 22: 455-465. KAEN, F.R., AND G.A. HACHEY, ‘Eurocurrency and National Money Market Interest Rates: An Empirical Investigation of Causality,‘JournalofMong, Credit and Banking, August 1983,lS: 327338. KAEN, F.R., B.P. HELMS, AND G.G. BOOTH, ‘The Integration of Eurodollar and U.S. Money Market Interest Rates in the Futures Market,’ Weltwirtscbaftlicber Arc&v, 1983, 119: 601-615. KREICHER, L.L., ‘Eurodollar Arbitrage,’ Federal Reserve Bank ofNew YorkQuarterb Review, Summer 1982, 7: 10-22. KWACK, S.Y., ‘The Structure of International Interest Rates: An Extension of Hendershott’s Tests,’ Journal of Finance, September 1971, 26: 897-900.