Rapid expansion of global hedge fund products and the increasing prominence of international finance have combined to lead tremendous growth in international equity flows over the last two decades. As a result of this heightened activity, equity flows have arguably become an important determinant of short-run supply and demand of foreign-exchange (FX) balances. In this journal article, INSEAD Associate Professor of Finance Harald Hau and Princeton's Hélène Rey argue that global portfolio rebalancing, motivated by efforts to limit exchange rate risk exposure, has a significant impact on FX rates and equity market returns. The study examines these effects through performing empirical analysis on bilateral equity flows between the United States and five equity markets: France, Germany, Japan, Switzerland, and the United Kingdom.
The first hypothesis argues that equity price changes motivate portfolio rebalancing. When, for example, foreign equity markets outperform US markets, geographic asset weights automatically shift, increasing FX risk exposure for US investors. To manage risk, foreign holdings will be reduced to restore previous levels and comply with investment mandates. Repatriation of foreign equity wealth increases demand for dollar balances, appreciating the dollar, given a price-elastic currency supply. This effect is most applicable to equity portfolios where FX risk is typically not hedged. In the second hypothesis, portfolio rebalancing occurs as a response to FX rate innovations.
When foreign currency appreciates, foreign asset values (as measured in home currency) increase. Again, higher FX risk exposure will induce foreign outflows to restore pre-shock levels of FX risk. This effect is similar to the first hypothesis, with the key difference being that excess foreign gains are currency-based, instead of resulting from differential market performance in base currency terms. The third hypothesis argues a reciprocal effect, where FX rate changes and excess foreign returns are also caused by increased equity flows. Equity inflows into the home country lead to demand-based appreciation of home currency, and also induce excess market returns of the home equity market. This argument assumes again a price elastic supply of currency balances and equity, which results from limited arbitrage in the FX and equity markets.
The data confirmed the role of equity returns as a catalyst, as excess foreign equity returns were consistently followed by equity flows from foreign countries to the United States. Investors reduced FX exposure after foreign wealth share increased in all countries examined, supporting the first hypothesis. The exchange-rate impact was immediate and positive in each case, with the US dollar appreciating as equity funds flowed into the United States. A 4-percent excess return in French equity brought an average 5-percent equity outflow from France to the United States, leading to a 2-percent dollar appreciation. The second hypothesis was supported by the fact that a positive shock to the dollar (USD appreciation relative to foreign currency) led to US equity outflows to each of the five countries studied. Here, portfolio balancing could be observed as equity was reallocated away from markets after excess returns occurred. The third hypothesis also found support, as international-equity portfolio shocks were found to impact exchange rates and influence excess equity returns. Equity flow innovations produced persistent excess returns in foreign equity markets in each of the five countries. The FX rate impact was also persistent as portfolio flows from the United States to the five foreign markets examined, depreciated the dollar significantly. Variance decomposition revealed that equity-flow shocks and relative equity-return shocks explain between 10 and 20 percent of the FX variance, increasing to 20 percent for all five countries during the period 1997-2004.
As such, international data on equity-market returns, equity portfolio flows and exchange-rate returns prove to be consistent with effects of dynamic rebalancing of foreign equity positions by global investors, demonstrating that portfolio rebalancing plays a very significant role in the supply, demand and price levels of FX and equity markets worldwide. As the importance of international equity flows grows further, we can expect these channels of asset price determination to become even more prominent.
American Economic Review, May 2004