Exchange rates, equity prices, and capital flows

We develop an equilibrium model in which exchange rates, stock prices, and capital flows are jointly determined under incomplete foreign exchange (forex) risk trading. Incomplete hedging of forex risk, documented for U.S. global mutual funds, induces the following price and capital flow dynamics: Higher returns in the home equity market relative to the foreign equity market are associated with a home currency depreciation. Net equity flows into the foreign market are positively correlated with a foreign currency appreciation. The model predictions are strongly supported at daily, monthly, and quarterly frequencies for 17 OECD countries vis-à-vis the United States. Correlations are strongest after 1990 and for countries with higher equity market capitalization relative to GDP, suggesting that the observed exchange rate dynamics is indeed related to equity market development. The last 25 years have been characterized by a remarkable increase in international capital mobility. While gross cross-border transactions in bond and equity for the United States were equivalent to only 4 % of GDP in 1975, this share increased to 100 % in the early 1990s and has grown to 245 % by 2000. Furthermore, a growing proportion of these capital flows consists of equity as opposed to bank loans or government bonds1 The Deniz Igan provided outstanding research assistance. We thank Mike Woodford for his comments