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Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows and Exchange Rates?

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  • Hau, Harald
  • Rey, Hélène

Abstract

We explore whether the pattern of international equity returns, equity portfolio flows, and exchange rate returns are consistent with the hypothesis that (unhedged) global investors rebalance their portfolio in order to limit their exchange rate exposure when there are (1) relative equity return; and (2) exchange rate shocks. We also explore whether (3) equity flow shocks influence the exchange rates and relative equity prices. In the estimation of the VAR system we do not impose any causal ordering upon the primitive shocks, but instead identify the system based on theoretical priors about the contemporaneous conditional correlations between the three variables. International data for the five largest equity markets are consistent with a theory in which equity returns and portfolio rebalancing are an important source of exchange rate dynamics.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4517.

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Date of creation: Aug 2004
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Handle: RePEc:cpr:ceprdp:4517

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Keywords: F37; international finance;

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  1. Evans, Martin D.D. & Lyons, Richard K., 2008. "How is macro news transmitted to exchange rates?," Journal of Financial Economics, Elsevier, vol. 88(1), pages 26-50, April.
  2. H.Hau & W.Killeen & M.Moore, 2003. "How has the euro Changed the Foreign Exchange Market?," DNB Staff Reports (discontinued) 79, Netherlands Central Bank.
  3. Roberto Rigobon & Anna Pavlova, 2004. "Asset Prices and Exchange Rates," Econometric Society 2004 North American Winter Meetings 579, Econometric Society.
  4. Fabio Canova & Gianni De Nicolo, 2000. "Monetary disturbances matter for business fluctuations in the G-7," International Finance Discussion Papers 660, Board of Governors of the Federal Reserve System (U.S.).
  5. Harald Hau & Helene Rey, 2002. "Exchange Rate, Equity Prices and Capital Flows," NBER Working Papers 9398, National Bureau of Economic Research, Inc.
  6. Uhlig, Harald, 2005. "What are the effects of monetary policy on output? Results from an agnostic identification procedure," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 381-419, March.
  7. Martin D.D. Evans & Richard K. Lyons, 1999. "Order Flow and Exchange Rate Dynamics," NBER Working Papers 7317, National Bureau of Economic Research, Inc.
  8. Kenneth A. Froot & Tarun Ramadorai, 2002. "Currency Returns, Institutional Investor Flows, and Exchange Rate Fundamentals," NBER Working Papers 9080, National Bureau of Economic Research, Inc.
  9. Martin D.D. Evans & Richard K. Lyons, 2004. "A New Micro Model of Exchange Rate Dynamics," NBER Working Papers 10379, National Bureau of Economic Research, Inc.
  10. William P. Killeen & Richard K. Lyons & Michael J. Moore, 2001. "Fixed versus Flexible: Lessons from EMS Order Flow," NBER Working Papers 8491, National Bureau of Economic Research, Inc.
  11. William H. Branson & Dale W. Henderson, 1984. "The Specification and Influence of Asset Markets," NBER Working Papers 1283, National Bureau of Economic Research, Inc.
  12. Richard K. Lyons, 2006. "The Microstructure Approach to Exchange Rates," MIT Press Books, The MIT Press, edition 1, volume 1, number 026262205x, December.
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