Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows, and Exchange Rates?

We explore whether the pattern of international equity returns, equity portfolio flows, and exchange rate returns are consistent with the hypothesis that (unhedged) global investors rebalance their portfolio in order to limit their exchange rate exposure when there are (1) relative equity return and (2) exchange rate shocks. We also explore whether (3) equity flow shocks influence the exchange rates and relative equity prices. In the estimation of the VAR system we do not impose any causal ordering upon the primitive shocks, but instead identify the system based on theoretical priors about the contemporaneous conditional correlations between the three variables. International data for the five largest equity markets are consistent with a theory in which equity returns and portfolio rebalancing are an important source of exchange rate dynamics. ∗Department of Finance, Boulevard de Constance, 77305 Fontainebleau Cedex, France. Telephone: (0033-1) 6072 4484. Fax: (0033-1) 6072 4045. E-mail: [email protected]. ∗∗Department of Economics and Woodrow Wilson School, Princeton University, Princeton, NY , USA. Telephone: (001) 609 258 6726. E-mail: [email protected]. We are grateful to the Fondation Banque de France for financial support.