Uncovered equity parity (UEP)—an emerging theory in international finance—suggests a relationship between foreign equity market performance and subsequent exchange rate movements. The authors agree with some aspects of UEP theory but provide additional insight as to why investors reallocate their foreign holdings that does not agree with UEP.
There is convincing evidence showing that strong currency movements are positively correlated with equity flows. More difficult to ascertain are data that support what uncovered equity parity (UEP) presumes: that investors desire to reduce foreign currency exposure by repatriating foreign equity when their foreign equity portfolios have outperformed relative to domestic markets. However, the authors find that portfolio rebalancing has little to do with reducing foreign exchange risk but instead is correlated with positioning for higher equity returns.
How Is This Research Useful to Practitioners?
The UEP condition provides a theory about international exchange rate movements. UEP is based on the idea that when foreign equity holdings outperform domestic holdings, a domestic investor’s portfolio has increased exposure to foreign currency risk. To reduce this increased risk, the investor will sell some of the foreign holdings. The mechanics of the selling lead to foreign currency depreciation. Using portfolio allocation data for US investors from Bertaut and Tryon (FRB International Finance Discussion Paper 2007) and country-level return data from MSCI, the authors examine the empirical relationship of US investors’ portfolio reallocations and returns over a 20-year period (1990–2010) to determine whether UEP adequately describes this process.
They find strong evidence that, consistent with UEP, investors sell foreign equity markets that have recently performed well. But the data show that they reduce their foreign equity holdings not to reduce foreign currency risk but to correctly time markets that subsequently perform relatively well. In other words, investors are seeking appreciation in the underlying equities and not repositioning their portfolios because of currency movements. Although the analysis supports some evidence that is consistent with UEP (i.e., investors sell foreign equities that have recently performed well), there is other evidence that is inconsistent with UEP (i.e.,investors sell foreign equity primarily to increase expected returns, not to reduce currency risk in their portfolios). Interestingly, the behavior is asymmetric; the authors do not find increased flows into markets that have recently performed very poorly.
How Did the Authors Conduct This Research?
The authors analyze 42 foreign markets, including both advanced and emerging market economies. They use the Bertaut and Tryon (2007) data on US investors’ monthly equity positions from 1990 to 2010. The holdings represent more than 89%, or $4,161 billion of the $4,647 billion, of US foreign equity holdings as of December 2010.
Although they provide evidence that US investor trading patterns arise from a relationship between equity returns and portfolio adjustments, the authors find no evidence of a particular trading strategy with respect to currency movements. Their analysis generally agrees with UEP theory but only up to a point. The behavior put forward by the UEP literature—that investors rebalance to reduce currency exposure—is not supported by the data. Although the authors highlight that data limitations prohibit a comprehensive explanation, the results are consistent with other empirical studies on the predictability of equity prices and currency movements. Currency movements, like many investable assets, have been shown to be extremely difficult to predict in the short term. It would be surprising to find that investors are primarily reallocating assets based on recent currency fluctuations, as the UEP theory suggests.