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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.

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  • 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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    Cited by:

    1. Kunkler, Michael & MacDonald, Ronald, 2018. "Decomposition of the uncovered equity parity correlation," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 57(C), pages 44-58.
    2. Afees A. Salisu & Juncal Cuñado & Kazeem Isah & Rangan Gupta, 2021. "Stock markets and exchange rate behavior of the BRICS," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 40(8), pages 1581-1595, December.
    3. Abuelfadl, Moustafa & Yamani, Ehab, 2021. "Currency news and international bond markets," The North American Journal of Economics and Finance, Elsevier, vol. 58(C).
    4. Wan, Li & Han, Liyan & Xu, Yang & Matousek, Roman, 2021. "Dynamic linkage between the Chinese and global stock markets: A normal mixture approach," Emerging Markets Review, Elsevier, vol. 49(C).
    5. Kanchanapoom Termkiat & Padungsaksawasdi Chaiyuth & Chunhachinda Pornchai & de Boyrie Maria E., 2018. "Uncovered Interest Rate Parity, Carry Trade, and Country Equity Return Differentials," Global Economy Journal, De Gruyter, vol. 18(3), pages 1-11, September.
    6. Tshikalange, Mulanga & Bonga-Bonga, Lumengo, 2023. "The determinants of the dynamic correlation between foreign exchange and equity markets: Cross-Country comparisons," MPRA Paper 118401, University Library of Munich, Germany.

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    More about this item

    Keywords

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

    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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