Working Paper: CEPR ID: DP4517
Authors: Harald Hau; Hléne Rey
Abstract: We explore whether the pattern of international equity returns, equity portfolio flows, and exchange rate returns are consistent with the hypothesis that (unhedged) global investors rebalance their portfolio in order to limit their exchange rate exposure when there are (1) relative equity return; and (2) exchange rate shocks. We also explore whether (3) equity flow shocks influence the exchange rates and relative equity prices. In the estimation of the VAR system we do not impose any causal ordering upon the primitive shocks, but instead identify the system based on theoretical priors about the contemporaneous conditional correlations between the three variables. International data for the five largest equity markets are consistent with a theory in which equity returns and portfolio rebalancing are an important source of exchange rate dynamics.
Keywords: International Finance
JEL Codes: F30; F31; F37
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| equity price shocks (G19) | foreign equity outflows (F21) |
| equity price shocks (G19) | dollar appreciation (F31) |
| exchange rate shocks (F31) | dollar share of assets in foreign market (G15) |
| exchange rate shocks (F31) | foreign equity market outflows (F21) |
| exchange rate shocks (F31) | foreign equity excess returns (G15) |
| equity flow innovations (O36) | changes in currency demand (E41) |
| equity flow innovations (O36) | equity market returns (G12) |
| equity flow inflow (F21) | foreign currency appreciation (F31) |