Indian financial markets have come a long way from the highly controlled pre-liberalization era. Today, their focus is on achieving efficiency, which is the hallmark of any developed financial market. This paper tests the efficiency and extent of integration between financial markets empirically at the short end of the market. The rates, mainly taken for the purpose of this study, comprise the call market rate, CD (Certificate of Deposit) rate, CP (Commercial Paper) rate, 91-day T-bill (Treasury bill) rate and 3-month forward premium. The results, though promising, are mixed. Therefore although markets have achieved integration in some pockets, they have still to achieve full integration. This has veritable implications on the monetary policy of the Reserve Bank of India (RBI) since changes in one market (gilt market) can be used to regulate the other market (forex market). This would give an additional tool to RBI, rather than resorting to direct intervention, which is the sign of a weak financial system.

A well-developed financial sector is the key to promote growth in an economy. A thriving financial sector promotes savings, allocates resources efficiently and provides the channel for transmission of monetary policy impulses. Integration of markets is the key condition for the transmission of policies. The purest measure of market integration is the degree to which the law of one-price holds in the financial markets. In the integrated financial markets, the law of one-price requires that identical financial assets should yield the same rate of return irrespective of where they are traded.

While measuring the integration of financial markets, most studies have been concerned with measuring the operating efficiency (Cole, et al. 1997) of the market rather than the allocative efficiency, which is central to the definition on integration. Measuring the operating efficiency is done by the process of comparing the rates between two markets with a reference rate. This is done by measuring the correlation coefficient. This procedure suffers from a major flaw of non-stationarity of variables. This makes the use of unit root and co-integration mandatory in this field of study.