Working Paper: NBER ID: w9101
Authors: Kenneth A. Froot; Tarun Ramadorai
Abstract: We explore the interaction between exchange rates, institutional investor currency flows and exchange-rate fundamentals. We find that these flows are highly correlated with contemporaneous and lagged exchange rate changes, and that they carry information for future excess currency returns. This information, however, is not strongly linked to future fundamentals. Flows are important in understanding transitory elements of excess returns, which include short-run underreaction and long-run overreaction. However, flows have a zero or negative correlation with permanent components of excess returns. We find that measured fundamentals - not flows - seem important in understanding permanent elements of excess returns. We conclude that investor flows are important for understanding deviations of exchange rates from fundamentals, but not for understanding the long-run currency values.
Keywords: Currency Returns; Investor Flows; Exchange Rate Fundamentals
JEL Codes: G11; G15; F21; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Institutional investor flows (G23) | Exchange rate changes (F31) |
| Institutional investor flows (G23) | Excess returns (G19) |
| Expected return news (G17) | Excess currency returns (F31) |
| Surprise currency appreciations (F31) | Institutional investor flows (G23) |
| Negative short-run expected return shock (D84) | Institutional investor outflows (G23) |
| Institutional investor flows (G23) | Short-term demand shocks (E32) |