DIVERSIFICATION AND REAL EXCHANGE RATE HEDGING IN EQUITY HOLDINGS

Abstract

The purpose of this paper is to examine the allocation of cross-border equity holdings and provide evidence that investors use equities to hedge real exchange fluctuations. The famous Backus-Smith (1993) condition, that relates the real exchange rates and relative consumption, is utilized in a two-country endowment economy introduced by Coeurdacier and Gourinchas (2009), in this case however, only stocks are traded. An important relationship between the real exchange rates, relative returns and equity positions is uncovered and subsequently incorporated into a gravity model developed by Coeurdacier and Guibaud (2011). Based on the uncovered relationship a new explanatory variable representing the correlation between the changes in real exchange rates and excess returns is utilized as a measure of the variation in bilateral equity holdings. If negative correlations imply home bias and positive correlations foreign bias, then given the particular market characteristics, the model measures whether investors hold equities to hedge the fluctuations in real exchange rate returns to smooth consumption. Although the primary results confirm the proposition, the findings vary with respect to the specifications included, and more empirical testing should be conducted.