Exchange Rates, Equity Prices, and Capital Flows

We develop an equilibrium model in which exchange rates, stock prices, and capital flows are jointly determined under incomplete foreign exchange (forex) risk trading. Incomplete hedging of forex risk, documented for U.S. global mutual funds, induces the following price and capital flow dynamics: Hi...

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Bibliographic Details
Published in:The Review of financial studies 2006-04, Vol.19 (1), p.273-317
Main Authors: Hau, Harald, Rey, Hélène
Format: Article
Language:English
Subjects:
Capital flow
Correlation analysis
Correlations
Cross-national analysis
Currency
Economic models
Electronic trading systems
Equity
Exchange rates
Financial economics
Financial models
Foreign exchange
Foreign exchange markets
Foreign exchange rate risk
Foreign exchange rates
GDP
Gross Domestic Product
Hedging
Institutional investments
Investment risk
Investors
Macroeconomics
Model testing
Risk management
Securities markets
Stock markets
Stock prices
Studies
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Summary:We develop an equilibrium model in which exchange rates, stock prices, and capital flows are jointly determined under incomplete foreign exchange (forex) risk trading. Incomplete hedging of forex risk, documented for U.S. global mutual funds, induces the following price and capital flow dynamics: Higher returns in the home equity market relative to the foreign equity market are associated with a home currency depreciation. Net equity flows into the foreign market are positively correlated with a foreign currency appreciation. The model predictions are strongly supported at daily, monthly, and quarterly frequencies for 17 OECD countries vis-à-vis the United States. Correlations are strongest after 1990 and for countries with higher equity market capitalization relative to GDP, suggesting that the observed exchange rate dynamics is indeed related to equity market development.
ISSN:0893-9454
1465-7368
DOI:10.1093/rfs/hhj008