Abstract
We examine international equity allocations at the fund level and show how excess foreign returns influence portfolio rebalancing, capital flows and currencies. Our equilibrium model of incomplete FX risk trading where exchange rate risk partially segments international equity markets is consistent with the observed dynamics of equity returns, exchange rates, and fund-level capital flows. We document that rebalancing is more intense under higher FX volatility and find heterogeneous rebalancing behavior across di¤erent fund characteristics. A granular instrumental variable (GIV) approach identifies a currency supply elasticity suggesting that an equity outflow shock of US$7.1 billion depreciates the dollar by 1 percent.
Highlights
Understanding the links between exchange rates and capital ‡ows is a long standing issue in international economics
How do international investors adjust their risk exposure in response to the ‡uctuations in realized returns they experience on their positions? Do they rebalance their portfolios toward their desired weights or do they increase their exposure to appreciating assets? What are the consequences of those portfolio decisions for capital ‡ows and exchange rate dynamics?
This paper documents a pervasive feature of the international equity portfolios of institutional investors, namely that they repatriate capital after making an excess return on their foreign portfolio share relative to their domestic equity investment
Summary
Understanding the links between exchange rates and capital ‡ows is a long standing issue in international economics. The granular instrumental variable (GIV) estimator developed by Gabaix and Koijen (2020) allows us to estimate the causal e¤ect of equity ‡ows on exchange rate changes These empirical results are consistent with the predictions of our two-country model featuring equity market segmentation and limits to intertemporal FX arbitrage, optimal portfolio choice by mean-variance investors and an equilibrium determination of the exchange rate. We outline a model of dynamic portfolio rebalancing in which representative home and foreign investors optimally adjust to the endogenously determined asset prices and exchange rate ‡uctuations. Both investors behave competitively and are price takers. The model features a unique equilibrium for the joint equity price, exchange rate, and portfolio holding dynamics under these linearizations and reasonable parameter values.
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