Currency Returns, Institutional Investor Flows and Exchange Rate Fundamentals

Abstract

We explore the interaction between exchange rates, institutional investor currency flows and exchange-rate fundamentals. We find that these flows are highly correlated with contemporaneous and lagged exchange rate changes, and that they carry information for future excess currency returns. This information, however, is not strongly linked to future fundamentals. Flows are important in understanding transitory elements of excess returns, which include short-run underreaction and long-run overreaction. However, flows have a zero or negative correlation with permanent components of excess returns. We find that measured fundamentals - not flows - seem important in understanding permanent elements of excess returns. We conclude that investor flows are important for understanding deviations of exchange rates from fundamentals, but not for understanding the long-run currency values.