Capital Flows and Exchange Rates: An Empirical Analysis

Siourounis, G (2003) Capital Flows and Exchange Rates: An Empirical Analysis. Working Paper. London Business School IFA Working Paper.

Abstract

This paper investigates the empirical relationship between capital flows and nominal exchange rates for five major countries. This is motivated by the recent international fice theory which suggests that currencies are as much influenced by capital flows as by current account balances and longterm interest rates. Using unrestriced VAR's we document the following: a) Incorporating net crossborder equity flows into standard linear empirical exchange rate models can improve their insample performance, whereas net crossborder bond flows are immaterial for exchange rate movements; b) Positive innovations to home equity returns (relative to the foreign markets) are associated with shortrun 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 longrun interpretation of uncovered interest rate parity (UIP); c) An equityaugmented 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.