Capital Flows and Exchange Rates: An Empirical Analysis

Economics

IFA Working Paper

2003

This paper investigates the empirical relationship between capital flows and nominal exchange rates for five major countries. This is motivated by the recent international finance theory which suggests that currencies are as much influenced by capital flows as by current account balances and long-term interest rates. Using unrestriced VAR's we document the following: a) Incorporating net cross-border equity flows into standard linear empirical exchange rate models can improve their in-sample performance, whereas net cross-border bond flows are immaterial for exchange rate movements; b) Positive innovations to home equity returns (relative to the foreign markets) are associated with short-run home currency appreciations and equity inflows, whereas positive shocks to home interest rates (relative to the foreign countries) cause currency movements that are consistent with the long-run interpretation of uncovered interest rate parity (UIP); c) An equity-augmented linear model provides support for exchange rate predictability and outperforms a random walk in several cases. However, the particular specification that can produce such superior forecast performance depends on the exchange rate and the forecast horizon. Our results are robust to a number of specifications.

IFA 400

IFA Working Paper

No