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The impact of exchange rate deviations from relative PPP equilibrium on the U.S. demand for foreign equities

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  • Grossmann, Axel
  • Paul, Chris
  • Simpson, Marc W.

Abstract

Applying fixed-effects panel data, this study investigates the impact of U.S. dollar exchange rate movements during different exchange rate states (overvaluation and undervaluation) on the monthly real gross and real net purchases of foreign equities by U.S. residents over the post-Plaza Accord period. The foreign equities come from 22 developed and 25 developing countries. Previous research has posited two alternative hypotheses regarding the relationship between exchange rates and foreign investment. These are the wealth effect and the profit-oriented effect. The evidence herein suggests that these two hypotheses coexist. We find robust evidence for a negative relationship between the exchange rate movements of an undervalued U.S. dollar and the demand for foreign equities. For developed countries, the wealth effect dominates the profit-oriented effect when the U.S. dollar is overvalued, while, for developing countries, the profit-oriented effect dominates the wealth effect. The results emphasize the importance of considering exchange rate states derived from a relative PPP equilibrium when analyzing U.S. allocations to foreign equities. The findings with respect to the macroeconomic control variables are mainly in agreement with the predictions of international financial theory. Some of the results, however, disappear or become inconclusive for the period after the bankruptcy of Lehman Brothers. This may be explained by the increased uncertainty in international financial markets following this unprecedented event. The findings are robust with respect to different constructed equilibrium exchange rates.

Suggested Citation

  • Grossmann, Axel & Paul, Chris & Simpson, Marc W., 2017. "The impact of exchange rate deviations from relative PPP equilibrium on the U.S. demand for foreign equities," Journal of International Money and Finance, Elsevier, vol. 77(C), pages 57-76.
  • Handle: RePEc:eee:jimfin:v:77:y:2017:i:c:p:57-76
    DOI: 10.1016/j.jimonfin.2017.06.005
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    Cited by:

    1. Grossmann, Axel & Ngo, Thanh & Simpson, Marc W., 2017. "The asymmetric impact of currency purchasing power imparities on ADR mispricing," Journal of Multinational Financial Management, Elsevier, vol. 42, pages 74-94.

    More about this item

    Keywords

    Foreign equities; Exchange rates; Macroeconomic variables; Deviations from relative PPP; Overvaluation and Undervaluation;

    JEL classification:

    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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