Exchange Rate, Equity Prices and Capital Flows

49 Pages Posted: 27 Feb 2003  

Harald Hau

University of Geneva - Geneva Finance Research Institute; Swiss Finance Institute; Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute)

Hélène Rey

London Business School; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: February 2003

Abstract

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.

Keywords: Capital flows, equity flows, market incompleteness, forex hedging

JEL Classification: F30, F31, G10, G15

Suggested Citation

Hau, Harald and Rey, Hélène, Exchange Rate, Equity Prices and Capital Flows (February 2003). CEPR Discussion Paper No. 3735. Available at SSRN: https://ssrn.com/abstract=383702

Harald Hau

University of Geneva - Geneva Finance Research Institute ( email )

40, Boulevard du Pont d'Arve
CH 1211 Geneva 4
Geneva
Switzerland

Swiss Finance Institute

Switzerland

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

Helene Rey (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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