Working Paper: CEPR ID: DP3735
Authors: Harald Hau; Hléne Rey
Abstract: We develop an equilibrium model in which exchange rates, stock prices and capital flows are jointly determined under incomplete forex risk trading. Incomplete hedging of forex risk, documented for US global mutual funds, has three important implications: 1) exchange rates are almost as volatile as equity prices when the forex liquidity supply is not infinitely price elastic; 2) higher returns in the home equity market relative to the foreign equity market are associated with a home currency depreciation; 3) net equity flows into the foreign market are positively correlated with a foreign currency appreciation. The model predictions are strongly supported at daily, monthly and quarterly frequencies for 17 OECD countries vis-à-vis the US Moreover, correlations are strongest after 1990 and for countries with higher market capitalization relative to GDP, suggesting that the observed exchange rate dynamics is indeed related to equity market development.
Keywords: capital flows; equity flows; forex hedging; market incompleteness
JEL Codes: F30; F31; G10; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| market incompleteness + low price elasticity of forex liquidity supply (D52) | exchange rate volatility (F31) |
| higher returns in home equity market relative to foreign equity market (G15) | depreciation of home currency (F31) |
| net equity flows into foreign market (F21) | foreign currency appreciation (F31) |