Cross-Country Equity Investment and Exchange Rate Dynamics

Abstract

This paper develops a model of exchange rate dynamics that takes into account speculative positions in foreign and domestic equities in addition to the positions in short-term riskless deposits. The modeling of cross-country stock holdings is motivated by evidence that a large and ever-increasing proportion of currency flows has been directed towards national stock markets. To the extent that there is not perfect risk sharing, investors tend to hold currency risk and international equity risk as a bundle. This paper examines the impact of such cross-country covariance risk on the behavior of exchange rates. As in standard models, it is found that exchange rate dynamics depend on the short-term interest differential between the home and foreign currencies. However, this relationship is nonlinear in nature, with the sign and magnitude of the coefficient on the interest differential depending on a type of time-varying beta risk, which in turn depends on the conditional second moments of exchange rate returns and the return differential between foreign and domestic equities. Using multivariate GARCH (MGARCH) and rolling-window estimation techniques, we find evidence in support of the model. Our results have specific implications for the empirical breakdown of uncovered interest parity (UIP), suggesting that the traditional UIP regression is misspecified and that accounting for cross-country equity trading may help to explain the forward premium puzzle. A main feature of the model that differs from previous studies is that it generates a time-varying coefficient on the interest differential, which is consistent with empirical evidence that the UIP relationship has not been stable over time.