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

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  • Harald Hau
  • Helene Rey

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.

Suggested Citation

  • Harald Hau & Helene Rey, 2004. "Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows, and Exchange Rates?," NBER Working Papers 10476, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:10476
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    1. Martin D.D. Evans & Richard K. Lyons, 2017. "Order Flow and Exchange Rate Dynamics," World Scientific Book Chapters,in: Studies in Foreign Exchange Economics, chapter 6, pages 247-290 World Scientific Publishing Co. Pte. Ltd..
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    4. 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.
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    6. Richard K. Lyons, 2006. "The Microstructure Approach to Exchange Rates," MIT Press Books, The MIT Press, edition 1, volume 1, number 026262205x, May.
    7. Martin D. D. Evans & Richard K. Lyons, 2017. "How is Macro News Transmitted to Exchange Rates?," World Scientific Book Chapters,in: Studies in Foreign Exchange Economics, chapter 14, pages 547-596 World Scientific Publishing Co. Pte. Ltd..
    8. Anna Pavlova & Roberto Rigobon, 2007. "Asset Prices and Exchange Rates," Review of Financial Studies, Society for Financial Studies, vol. 20(4), pages 1139-1180.
    9. 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.
    10. Canova, Fabio & Nicolo, Gianni De, 2002. "Monetary disturbances matter for business fluctuations in the G-7," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1131-1159, September.
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    12. Harald Hau & Hélène Rey, 2006. "Exchange Rates, Equity Prices, and Capital Flows," Review of Financial Studies, Society for Financial Studies, vol. 19(1), pages 273-317.
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    JEL classification:

    • F30 - International Economics - - International Finance - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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