Working Paper: NBER ID: w10476
Authors: Harald Hau; Hélène 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: No keywords provided
JEL Codes: F30; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| foreign equity market appreciations (G15) | home investors reduce foreign equity holdings (G15) |
| home investors reduce foreign equity holdings (G15) | reduce exchange rate risk exposure (F31) |
| reduce exchange rate risk exposure (F31) | foreign equity outflows (F21) |
| foreign equity outflows (F21) | dollar appreciation (F31) |
| foreign currency appreciation (F31) | increases dollar share of assets in foreign market (G15) |
| increases dollar share of assets in foreign market (G15) | heightens FX risk exposure for home investors (G15) |
| heightens FX risk exposure for home investors (G15) | foreign equity market outflows (F21) |
| heightens FX risk exposure for home investors (G15) | negative foreign equity excess returns (G12) |
| equity flow innovations (O16) | appreciate foreign currency relative to home currency (F31) |
| equity flow innovations (O16) | induce excess returns in foreign equity market (G15) |
| equity flow innovations (O16) | negative correlation between net foreign equity flows and exchange rate returns (F21) |
| equity flow innovations (O16) | positive correlation between equity flows and foreign excess returns (F21) |