International Parity Conditions and Market Risk.pdf

International Parity Conditions and Market Risk Thomas C. Chiang, Ph.D. Austin Professor of Finance Drexel University Date: March 15, 2003 Keywords: International Asset Pricing , Purchasing Power Parity, Uncovered Interest Parity, Exchange Rate Risk, Equity Premiums, Real Interest Rate Parity Correspondence Thomas C. Chiang Department of Finance, Drexel University 3141 Chestnut Street, Philadelphia, Pa. 19104, USA Tel: (215) 895-1279; Fax: (215) 895-2955 Email: chiangtc@ File: International Parity Conditions_v2 Abstract This article presents a set of international parity conditions based on consistent efficient market behavior. We hypothesize that deviations from parity conditions in international bond, stock, and commodity markets are attributable mainly to relative equity premiums and real interest-rate differentials. Testing this hypothesis against four European markets for the recent floating period, we gain supportive evidence. Moreover, the deviations of uncovered-interest parity, international stock-return parity, and purchasing-power parity are not independent; the evidence suggests that deviations from the three parities are driven by two common factors. 2 International Parity Conditions and Market Risk 1. Introduction In the past three decades of a floating period on exchange rates, a substantial amount of research has been devoted to identifying linkages in international markets. The most pro