The dynamics. We propose an arbitrage relationship

The need to understand the mechanics of exchange rates and their developments has generated avast theoretical and empirical literature. The flexible price monetary model, which subsequentlygave way to the overshooting or sticky-price model, the equilibrium and liquidity models as well asthe portfolio balance approach have characterised three decades of research, from the 1960s to the1980s. More recently, since the publication of Obstfeld and Rogoff’s (1995) seminal “redux” paper,the new open-economy macroeconomics has attempted to explain exchange rate developments inthe context of dynamic general equilibrium models that incorporate imperfect competition andnominal rigidities. Empirically, these theoretical developments have fared poorly at explainingexchange rate dynamics, at least over relatively short horizons, and several exchange rate puzzleshave been highlighted.

The increasing role played by international financial markets in developed economiesconstitutes a persuasive argument to explore possible relationships between returns on risky assetsand exchange rates dynamics. Recently, a new strand of research has investigated theinterconnections between equity and bond returns, on one side, and exchange rate dynamics, on theother side, with promising results (see Brandt et al., 2001; Pavlova and Rigobon, 2003; Hau andRey, 2004 and 2005).In this paper, by employing the Lucas’ (1982) consumption economy model, we introduce anew framework explaining exchange rate dynamics. We propose an arbitrage relationship betweenexpected exchange rate changes and differentials in expected equity returns of two economies.Specifically, if expected returns on a certain equity market are higher than those obtainable fromanother market, the currency associated with the market that offers higher returns is expected todepreciate. A resident in the market which offers higher expected returns suffers a loss wheninvesting abroad, and therefore she has to be compensated by the expected capital gain that occurswhen the foreign currency appreciates. This ensures that no sure opportunities for unboundedprofits exist and, therefore, the equilibrium is re-established.

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Due to the similarity with theUncovered Interest Parity (UIP) condition, the equilibrium hypothesis proposed and tested here isbaptised Uncovered Equity Return Parity condition (URP). There is, however, a key differencebetween the two arbitrage relations. In the UIP return differentials are known ex ante, since they arecomputed on risk-free assets, while in the URP are not.Risk-averse agents investing in risky assets denominated in a foreign currency usuallyrequire a market and a foreign exchange risk premium, which can be time varying. We begin ourstudy assuming that investors are risk-neutral, which implies that the URP does not include risk5ECBWorking Paper Series No. 529September 2005premia. Next, we relax the risk-neutrality assumption and we enrich the URP by employingadditional financial variables, which are related to the business cycle. We use differentials incorporate earnings’ growth rates, short-term interest rate changes, and annual inflation rates, as wellas net equity flows.

In line with previous studies (see, for instance, Fama and French, 1989; Chen,1991; and Ferson and Harvey, 1991b), these variables can be thought of as proxies for the riskpremia. The URP with risk premia turns out to explain.

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