Explaining movements of nominal exchange rates is perhaps one of the most intriguing themes in international macroeconomics. This paper investigates the empirical relationship between capital flows and nominal exchange rates. This relation is often stressed as important—Dornbush (1976, p. 1166), for example, states that ‘the exchange rate adjusts instantaneously to clear the asset market’—but the available empirical evidence on such a link is scarce.
We model net capital flows and nominal exchange rates in a unified empirical framework, in which the same forces that drive exchange rates also influence countries’ cross border asset holdings, and argue that a great deal can be learned about foreign exchange markets by examining capital markets.
We document that 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. Positive innovations to home equity returns (relative to the foreign markets) are associated with short-run home currency appreciations and equity inflows, whereas shocks to home interest rates (relative to the foreign countries) cause long-run currency movements that are consistent with a long-run interpretation of uncovered interest rate parity (UIP).
Furthermore, the empirical model outperforms a random walk in out-of-sample forecasting ability in several cases, a finding that is extremely interesting in light of the seminal contribution by Meese and Rogoff (1983). Our findings are consistent with the recent international finance literature but our empirical methodology deviates from it in some important dimensions. Treating all variables as endogenous, we formally test which asset flow is relevant for monthly exchange rates, we decompose the dynamic effects that a structural shock to net capital flows has on exchange rates, and we assess theoretical implications for the dynamic cross-correlations of exchange rates with both equity return differentials and interest rate differentials.