Can risk-rebalancing explain the negative correlation between stock return differential and currency? Or, does source status drive it?
Numan Uelkue, Sabutay Fatullayev, Dania Diachenko
Journal of Financial Markets | ELSEVIER SCIENCE BV | Published : 2016
We show that Hau and Rey[U+05F3]s (2006) empirical evidence is not sufficient to support their risk-rebalancing theory as an explanation for the negative correlation between the stock market return differential and currency. A simple model combining home-wealth rebalancing and extrapolative expectations on the foreign stock predicts this negative correlation only when the host market is a source of international capital. Panel regressions indicate that the source status of the economy (i.e., whether it is a net receiver or source of international capital) is a main predictor of the stock return differential-currency correlation.