Can cross-country portfolio rebalancing give rise to forward bias in FX markets?
AbstractThis paper develops a model of exchange rate dynamics that takes into account positions in foreign and domestic equities in addition to “standard” short-term riskless securities. The modeling of cross-country stock holdings is motivated by evidence that a large and ever-increasing proportion of currency flows has been directed toward national stock markets. To the extent that there is not perfect risk sharing, investors tend to hold currency risk and international equity risk as a bundle. This paper examines the impact of such cross-country covariance risk on the relationship between exchange rate returns and interest rate differentials. In particular, we show that the sign and magnitude of the coefficient on the lagged interest differential is governed by a type of time-varying beta risk that reflects the conditional covariance between exchange rate returns and the return differential between foreign and domestic equities. As this cross-country beta is predominantly negative, our results have direct implications on the empirical failure of the uncovered interest parity (UIP) hypothesis, suggesting that the traditional UIP regression equation is confounded (in a non-standard, nonlinear way) by the presence of cross-country equity flows. Simulation experiments show that accounting for such portfolio-rebalancing activities may, in part, help to explain the anomalous slope coefficient associated with the forward premium.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
Bibliographic InfoArticle provided by Elsevier in its journal Journal of International Money and Finance.
Volume (Year): 32 (2013)
Issue (Month): C ()
Contact details of provider:
Web page: http://www.elsevier.com/locate/inca/30443
Forward premium puzzle; Exchange rate dynamics; Portfolio rebalancing; Covariance risk; Multivariate GARCH; Fixed-design wild bootstrap;
Find related papers by JEL classification:
- F31 - International Economics - - International Finance - - - Foreign Exchange
- F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
- G19 - Financial Economics - - General Financial Markets - - - Other
You can help add them by filling out this form.
reading list or among the top items on IDEAS.Access and download statisticsgeneral information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Wendy Shamier).
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.