Evaluating the portfolio rebalancing hypothesis in the presence of the international goods market

Vol: 
85/2019
Author name: 
McKinnon K
Year: 
2019
Month: 
November
Abstract: 

A relatively recent approach to examining the currency-equity return relationship argues that the portfolio rebalancing activities of investors gives rise to an Uncovered Equity Parity condition (UEP), whereby higher relative equity returns in one country are associated with a currency depreciation as international investors re-jig positions to maintain optimal portfolio targets. There is some empirical evidence based on simple correlation analysis suggesting the UEP holds for many OECD countries, but it does not appear to be true for countries that rely heavily on primary commodity exports. This paper utilises a latent factor model to isolate shocks specific to the currency, equity and commodity markets so that the size and direction of cross market spillovers can be examined. Results from a model estimated for Australia, Canada and New Zealand are compared to those obtained using a benchmark OECD sample comprising Denmark, Sweden and the UK. The evidence is not supportive of the UEP for either country group, and there is particularly strong evidence of positive feedback between currency and equity markets for the benchmark OECD group. More generally, there are significant transmission mechanisms between all three asset markets for both commodity exporters and the benchmark OECD countries.

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