Uncovered equity parity explains how equity portfolio rebalancing affects exchange rates. Outperformance of foreign stock markets, whether through the exchange rate or stock prices, leaves investors with excess exchange rate exposure. The reduction of this exposure then puts depreciation pressure on the foreign currency. A new Federal Reserve paper presents evidence for the essential parts of that theory.
Board of Governors of the Federal Reserve System, International Finance Discussion Papers, Number 1103 May 2014
http://www.federalreserve.gov/pubs/ifdp/2014/1103/ifdp1103.pdf
The below paragraphs are excerpts from the paper. Cursive lines and emphasis have been added.
What is the uncovered equity parity?
“According to uncovered equity parity (UEP), when foreign equity holdings outperform domestic holdings, domestic investors are exposed to higher exchange rate exposure and hence repatriate some of the foreign equity to decrease their exchange rate risk… This rebalancing is a reaction to movements in the currency, the underlying equity market, or some combination of the two…By doing so, foreign currency is sold, leading to foreign currency depreciation.”
“Valuation effects have become ever more important determinants of changes in the external wealth of nations as gross international positions have become ever larger…As of end-2010 U.S. investors’ international equity holdings totaled USD4,647 billion [almost 30% of GDP]. Added to that is a small amount (USD500 billion) of U.S. holdings of foreign-currency denominated bonds issued by foreign entities… U.S. investors also hold the equities of U.S. multinationals that have operations in many foreign countries… Surveys of investors suggest that while international bond positions might be hedged, international equity positions are typically unhedged.”
What is the empirical evidence on the UEP
“Our final working dataset is monthly 1990 – 2010 for 42 foreign markets for which we have both U.S. portfolio weights and monthly equity returns.”
“Overall…two mechanisms behind UEP—price pressure and reallocating away from past winners—are strongly supported in the data…
- We find strong evidence—once appropriate techniques and data are used—that investors do indeed sell foreign equity markets that recently performed well….Why investors engage in this behavior, is somewhat more difficult to ascertain. UEP suggests investors reallocate to lessen the increased risk of currency exposure. An indirect test of this is to see if investors reallocate because of past currency movements. They do not. U.S. investors react to changes in underlying equity market returns in a manner consistent with partial equity rebalancing, trading away from equity markets that recently performed well and into ones that subsequently perform well. But we find that past currency movements have no influence on these portfolio shifts…
- We find strong evidence supporting the second leg of UEP: equity flows are contemporaneously positively correlated with currency movements, a relationship consistent with price pressure. This finding is neither controversial nor surprising, as many others have found such evidence.”
Why are U.S. investors rebalancing foreign equity portfolios?
