Exchange rate uncertainty and international portfolio flows: A multivariate GARCH-in-mean approach

Guglielmo Maria Caporale,Faek Menla Ali,Nicola Spagnolo

doi:10.1016/j.jimonfin.2015.02.020

Guglielmo Maria Caporale, Faek Menla Ali + Show 1 more

Open Access

https://doi.org/10.1016/j.jimonfin.2015.02.020

Copy DOI

Abstract

This paper examines the impact of exchange rate uncertainty on different components of net portfolio flows, namely net equity and net bond flows, as well as their dynamic linkages. Specifically, a bivariate VAR GARCH-BEKK-in-mean model is estimated using bilateral monthly data for the US vis-à-vis Australia, Canada, the euro area, Japan, Sweden, and the UK over the period 1988:01-2011:12. The results indicate that the effect of exchange rate uncertainty on net equity flows is negative in the euro area, the UK and Sweden, and positive in Australia. The impact on net bond flows is also negative in all countries except Canada, where it is positive. Under the assumption of risk aversion, the findings suggest that exchange rate uncertainty induces a home bias and causes investors to reduce their financial activities to maximise returns and minimise exposure to uncertainty, this effect being stronger in the UK, the euro area and Sweden compared to Canada, Australia and Japan. Overall, the results indicate that exchange rate or credit controls on these flows can be used as a policy tool in countries with strong uncertainty effects to pursue economic and financial stability.

Highlights

The macroeconomic effects of exchange rate uncertainty, especially on trade flows, have received considerable attention since the collapse of the Bretton Woods system in 1971 and the adoption of floating exchange rates in March 1973, both in the theoretical and empirical literature
We have analysed the impact of exchange rate uncertainty on net bond and net equity flows, as well as the dynamic linkages between exchange rate volatility and the variability of these flows, using monthly data for the US vis-a-vis six advanced economies, namely Australia, Canada, the euro area, Japan, Sweden, and the UK over the period 1988:01-2011:12
By estimating bivariate VAR GARCH-BEKK-in-mean models, we find evidence that exchange rate uncertainty impacts on net equity flows negatively in the euro area, Sweden, and the UK and positively in Australia

Summary

Introduction

The macroeconomic effects of exchange rate uncertainty, especially on trade flows, have received considerable attention since the collapse of the Bretton Woods system in 1971 and the adoption of floating exchange rates in March 1973, both in the theoretical and empirical literature (see McKenzie, 1999, for a comprehensive review). We use the most common time series measure of uncertainty found in the literature, i.e. the conditional variance modelled as a GARCH (1, 1) process (others are the continuous volatility measure in Portes and Rey (2005), the stochastic deviation from purchasing power parity (PPP) in Fidora et al (2007) and Mishra (2011), the standard deviation of exchange rate changes in Bekaert and Wang (2009) and the coefficient of variation of the real exchange rate in Mercado (2013)) This approach is flexible enough to allow for joint estimation of the relationship between uncertainty and portfolio flows taking into account past information on perceived uncertainty..

Data description and preliminary analysis

The econometric model

Empirical results

Findings

Conclusions