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Can cross-country portfolio rebalancing give rise to forward bias in FX markets?

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  • Chang, Sanders S.

Abstract

This paper develops a model of exchange rate dynamics that takes into account positions in foreign and domestic equities in addition to “standard” short-term riskless securities. The modeling of cross-country stock holdings is motivated by evidence that a large and ever-increasing proportion of currency flows has been directed toward national stock markets. To the extent that there is not perfect risk sharing, investors tend to hold currency risk and international equity risk as a bundle. This paper examines the impact of such cross-country covariance risk on the relationship between exchange rate returns and interest rate differentials. In particular, we show that the sign and magnitude of the coefficient on the lagged interest differential is governed by a type of time-varying beta risk that reflects the conditional covariance between exchange rate returns and the return differential between foreign and domestic equities. As this cross-country beta is predominantly negative, our results have direct implications on the empirical failure of the uncovered interest parity (UIP) hypothesis, suggesting that the traditional UIP regression equation is confounded (in a non-standard, nonlinear way) by the presence of cross-country equity flows. Simulation experiments show that accounting for such portfolio-rebalancing activities may, in part, help to explain the anomalous slope coefficient associated with the forward premium.

Suggested Citation

  • Chang, Sanders S., 2013. "Can cross-country portfolio rebalancing give rise to forward bias in FX markets?," Journal of International Money and Finance, Elsevier, vol. 32(C), pages 1079-1096.
  • Handle: RePEc:eee:jimfin:v:32:y:2013:i:c:p:1079-1096
    DOI: 10.1016/j.jimonfin.2012.09.002
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    Cited by:

    1. Narayan, Paresh Kumar & Sharma, Susan Sunila, 2015. "Does data frequency matter for the impact of forward premium on spot exchange rate?," International Review of Financial Analysis, Elsevier, vol. 39(C), pages 45-53.
    2. Baillie, Richard T. & Cho, Dooyeon, 2014. "Time variation in the standard forward premium regression: Some new models and tests," Journal of Empirical Finance, Elsevier, vol. 29(C), pages 52-63.
    3. Kang-Soek Lee, 2017. "Safe-haven currency: An empirical identification," Review of International Economics, Wiley Blackwell, vol. 25(4), pages 924-947, September.
    4. Ülkü, Numan & Fatullayev, Sabutay & Diachenko, Daria, 2016. "Can risk-rebalancing explain the negative correlation between stock return differential and currency? Or, does source status drive it?," Journal of Financial Markets, Elsevier, vol. 27(C), pages 28-54.
    5. Baillie, Richard T. & Kim, Kun Ho, 2015. "Was it risk? Or was it fundamentals? Explaining excess currency returns with kernel smoothed regressions," Journal of Empirical Finance, Elsevier, vol. 34(C), pages 99-111.
    6. Norman C. Miller, 2014. "Exchange Rate Economics," Books, Edward Elgar Publishing, number 14981.

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    More about this item

    Keywords

    Forward premium puzzle; Exchange rate dynamics; Portfolio rebalancing; Covariance risk; Multivariate GARCH; Fixed-design wild bootstrap;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G19 - Financial Economics - - General Financial Markets - - - Other

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