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Uncovered Equity Parity and Rebalancing in International Portfolios

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  • Curcuru, Stephanie E.

    ()
    (Board of Governors of the Federal Reserve System (U.S.))

  • Thomas, Charles P.

    ()
    (Board of Governors of the Federal Reserve System (U.S.))

  • Warnock, Francis E.

    (University of Virginia)

  • Wongswan, Jon

    (Phatra Securities Public Company Limited)

Abstract

Portfolio rebalancing is a key driver of the Uncovered Equity Parity (UEP) condition. According to UEP, when foreign equity holdings outperform domestic holdings, domestic investors are exposed to higher exchange rate exposure and hence repatriate some of the foreign equity to decrease their exchange rate risk. By doing so, foreign currency is sold, leading to foreign currency depreciation. We examine the relationship between U.S. investors' portfolio reallocations and returns and find some evidence consistent with UEP: Portfolio shifts are related to past returns in the underlying equity markets. But we argue that a motive other than reducing currency risk exposure is likely behind this rebalancing. In particular, U.S. investors may be exploiting mean reversion in underlying equity markets, rebalancing away from equity markets that recently performed well and moving into equity markets market just prior to relatively strong performance. Such behavior suggests tactical reallocations to increase returns rather than reduce risk.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 1103.

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Length: 41 pages
Date of creation: 15 May 2014
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Handle: RePEc:fip:fedgif:1103

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Keywords: Exchange rate determination; international returns; equity portfolios;

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