Exchange Rate, Equity Prices and Capital Flows
University of Geneva - Geneva Finance Research Institute; Swiss Finance Institute; Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute)
London Business School; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
CEPR Discussion Paper No. 3735
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 US 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-a-vis the US. 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.
Number of Pages in PDF File: 49
Keywords: Capital flows, equity flows, market incompleteness, forex hedging
JEL Classification: F30, F31, G10, G15
Date posted: February 27, 2003
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