Exchange Rate, Equity Prices and Capital Flows
We develop an equilibrium model in which exchange rates, stock prices and capital flows are jointly determined under incomplete forex risk trading. Incomplete hedging of forex risk, documented for U.S. global mutual funds, has three important implications: 1) exchange rates are almost as volatile as equity prices when the forex liquidity supply is not infinitely price elastic; 2) higher returns in the home equity market relative to the foreign equity market are associated with a home currency depreciation; 3) 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-…-vis the U.S. Moreover, correlations are strongest after 1990 and for countries with higher market capitalization relative to GDP, suggesting that the observed exchange rate dynamics is indeed related to equity market development.
Hau, Harald and Helene Rey. "Can Portfolio Rebalancing Explain The Dynamics Of Equity Returns, Equity Flows, And Exchange Rates?," American Economic Review, 2004, v94(2,May), 126-133.
Harald Hau & Hélène Rey, 2006. "Exchange Rates, Equity Prices, and Capital Flows," Review of Financial Studies, Oxford University Press for Society for Financial Studies, (Spring 2006) 19 (1): 273-317. citation courtesy of