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Can risk-rebalancing explain the negative correlation between stock return differential and currency? Or, does source status drive it?

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  • Ülkü, Numan
  • Fatullayev, Sabutay
  • Diachenko, Daria

Abstract

We show that Hau and Rey׳s (2006) empirical evidence is not sufficient to support their risk-rebalancing theory as an explanation for the negative correlation between the stock market return differential and currency. A simple model combining home-wealth rebalancing and extrapolative expectations on the foreign stock predicts this negative correlation only when the host market is a source of international capital. Panel regressions indicate that the source status of the economy (i.e., whether it is a net receiver or source of international capital) is a main predictor of the stock return differential–currency correlation.

Suggested Citation

  • Ülkü, Numan & Fatullayev, Sabutay & Diachenko, Daria, 2016. "Can risk-rebalancing explain the negative correlation between stock return differential and currency? Or, does source status drive it?," Journal of Financial Markets, Elsevier, vol. 27(C), pages 28-54.
  • Handle: RePEc:eee:finmar:v:27:y:2016:i:c:p:28-54
    DOI: 10.1016/j.finmar.2015.07.001
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    References listed on IDEAS

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    Keywords

    Exchange rates; Stock market return differentials; Equity portfolio flows; Portfolio rebalancing.;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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