Generalized Asset Return Parity and the Exchange Rate in a Finnancially open Economy

This paper examines the parity conditions between assets denominated in different currencies, traded in a well-integrated segment of the international capital market, and derives the consequences for exchange rate expectations. The main objective is to assess the uncovered asset return parity for the Czech koruna exchange rate. I argue that any reasonable, decision-theoretical foundation of the uncovered parity condition should be formulated in terms of secondary market yields on long-term instruments and not short-term money market rates. Specifically, this is how the international version of the Consumption-based Capital Asset Pricing Model (CCAPM), which is the universal (and, in fact, the single) message of any stochastic general equilibrium model of an open economy, should be interpreted. Accordingly, I replace the traditional uncovered interest rate parity (UIP) by the uncovered total return parity condition. The theoretical arguments in favor of the uncovered asset return parity are matched by a number of examples, of which the main group is formed by long-maturity government bonds. Data are examined for the Czech versus German 5-year government bonds, the CZK 10-year bonds of the European Investment Bank vs. German government 10-year bonds, as well as for the Austrian versus US-Treasury 10-year bonds. In both cases, parity seems to hold, although the time horizons and the measures of exchange rate movements for which it becomes visible are different. The proposed micro foundation of the uncovered asset return parity uses a model of consumption and investment in an open economy under diffusion uncertainty with soft liquidity constraints. The model is solved by means of the stochastic maximum principle including the adjoint equations for the co-state variables. The general equilibrium of portfolio optimizing investors is used to derive a breakdown of the country risk premium present in the uncovered asset return parity relation between a selected pair of financial instruments. This allows one to analyze the prevailing beliefs about the long-term exchange rate path. The basic consumption and investment model can be extended to the context of a productive firm issuing its own liabilities to cover liquidity needs. This extension leads to an analogous uncovered yield parity result. I show that the uncovered return parity from the producer perspective is the same as from the consumer and investor perspective. This opens a way for the exchange rate expectation-extraction by means of corporate bonds and other company-specific instruments. In addition, the disparity of returns in international equity markets possesses a certain explanatory power as regards expected competitiveness of domestic and foreign industries.