Working Paper: NBER ID: w19963
Authors: Stephanie E. Curcuru; Charles P. Thomas; Francis E. Warnock; Jon Wongswan
Abstract: Portfolio rebalancing is a key driver of the Uncovered Equity Parity (UEP) condition. According to UEP, when foreign equity holdings outperform domestic holdings, domestic investors are exposed to higher exchange rate exposure and hence repatriate some of the foreign equity to decrease their exchange rate risk. By doing so, foreign currency is sold, leading to foreign currency depreciation. We examine the relationship between U.S. investors' portfolio reallocations and returns and find some evidence consistent with UEP: Portfolio shifts are related to past returns in the underlying equity markets. But we argue that a motive other than reducing currency risk exposure is likely behind this rebalancing. In particular, U.S. investors may be exploiting mean reversion in underlying equity markets, rebalancing away from equity markets that recently performed well and moving into equity markets market just prior to relatively strong performance. Such behavior suggests tactical reallocations to increase returns rather than reduce risk.
Keywords: international finance; portfolio rebalancing; equity markets; currency exposure; mean reversion
JEL Codes: F21; F31; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Foreign equity performance (G15) | Increased exchange rate exposure (F31) |
| Increased exchange rate exposure (F31) | Selling of foreign currency (F31) |
| Selling of foreign currency (F31) | Foreign currency depreciation (F31) |
| Past equity market returns (G12) | Portfolio reallocations (G11) |
| Portfolio reallocations (G11) | Expected future returns (G17) |
| Foreign equity performance (G15) | Portfolio decisions (G11) |
| Portfolio decisions (G11) | Risk mitigation behavior (D91) |