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RFS Advance Access published online on October 28, 2005
Review of Financial Studies, doi:10.1093/rfs/hhj008
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© The Author 2005. Published by Oxford University Press on behalf of the by The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.

Article

Exchange Rates, Equity Prices and Capital Flows

Harald Hau 1* and Hélène Rey 2*
1 Department of Finance, Boulevard de Constance, 77305 Fontainebleau Cedex, France
2 Department of Economics and Woodrow Wilson School, Princeton University, Princeton, NJ 08544, USA

* To whom correspondence should be addressed.
Harald Hau, E-mail: harald.hau{at}insead.edu
Hélène Rey, E-mail: hrey{at}princeton.edu


  Abstract

We develop an equilibrium model in which exchange rates, stock prices and capital flows are jointly determined under incomplete forex risk trading. Incomplete hedging of forex risk, documented for U.S. global mutual funds, induces the following price and capital flow dynamics: Higher returns in the home equity market relative to the foreign equity market are associated with a home currency depreciation. Net equity flows into the foreign market are positively correlated with a foreign currency appreciation. The model predictions are strongly supported at daily, monthly and quarterly frequencies for 17 OECD countries vis-àvis the U.S. Correlations are strongest after 1990 and for countries with higher equity market capitalization relative to GDP, suggesting that the observed exchange rate dynamics is indeed related to equity market development.


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