Working Paper: CEPR ID: DP6901
Authors: Harald Hau; Hélène Rey
Abstract: The dramatic increase in gross stock of foreign assets and liability has revived interest in the portfolio balance theory of international investment. Evidence on the validity of this theory has always been scarce and inconclusive. The current paper derives testable empirical implications from microeconomic foundations, which we confront with a new comprehensive data set on the stock allocations of approximately 6,500 international equity funds domiciled in four different currency areas. The disaggregated data structure allows us to examine whether foreign exchange and equity risk measures trigger the predicted rebalancing behavior at the fund and stock level. The data provide strong support for portfolio rebalancing behavior aimed at reducing both exchange rate and equity risk exposure.
Keywords: capital flows; home bias; international finance
JEL Codes: F32; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher equity returns on foreign portfolio shares (G15) | Capital repatriation (F21) |
| Foreign asset underperformance (G15) | Capital expatriation (F21) |
| Valuation effects (D46) | Active rebalancing that decreases overall portfolio risk (G11) |
| Valuation effects (D46) | Active rebalancing that increases overall portfolio risk (G11) |
| Performance differentials (D29) | Rebalancing actions (D74) |
| Rebalancing behavior (D91) | Capital repatriation (F21) |
| Rebalancing behavior (D91) | Capital expatriation (F21) |