Non-Linear Aspects of Capital Market Integration

According to classic economic theory, if global capital markets are fully integrated then arbitrage should force real interests rates to be equal among countries. However, a large body of empirical evidence suggests that this parity is not achieved. One potential factor in this failure of economic theory is that international capital transactions are not frictionless. The costs involved in the purchase or sale of a capital asset imply a neutral area in which arbitrage is not profitable and rates freely deviate from equality. This paper uses a variety of econometric methods to investigate the behavioral characteristics of real interest rates and determine the existence and form of transactions costs.This work is divided into six sections. Section One introduces the concept of capital market integration and details the current state of the literature on the topic. Section Two describes the data used in the analyses. Section Three uses a non-parametric regression method to analyze bilateral real interest rate relationships. Section Four examines these relationships in a multivariate setting, employing a method which incorporates non-linear behavior. Section Five investigates the data for structural instability. Section Six briefly summarizes and concludes the paper.