We develop an equilibrium model in which exchange rates, stock prices and capital flows are jointly determined under incomplete forex risk trading. Incomplete hedging of forex risk, documented for U.S. global mutual funds, has three important implications: 1) exchange rates are almost as volatile as equity prices when the forex liquidity supply is not infinitely price elastic; 2) higher returns in the home equity market relative to the foreign equity market are associated with a home currency depreciation; 3) net equity flows into the foreign market are positively correlated with a foreign currency appreciation. The model predictions are strongly supported at daily, monthly and quarterly frequencies for 17 OECD countries visà-vis the U.S. Moreover, correlations are strongest after 1990 and for countries with higher market capitalization relative to GDP, suggesting that the observed exchange rate dynamics is indeed related to equity market development. Deniz Igan provided outstanding research assistance. Thanks also to participants in the 2002 NBER IFM summer institute, the 2003 European summer symposium in finanical markets, the FX microstructure conference at the Stockholm Institute for Finance and in seminars at Columbia, Finance sur Seine (Paris), Georgetown, George Washington University, and the IMF. We are both very grateful to the IMF Research Department for its warm hospitality and its stimulating

We analyze the effects of financial and trade globalization on the likelihood of financial crashes in emerging markets. While trade globalization always makes crashes less likely, financial globalization may make them more likely, especially when trade costs are high. Pessimistic expectations can be self-fulfilling and lead to a collapse in demand for goods and assets. Such a crash comes with a current account reversal and drops in income and investment. Lower-income countries are more prone to such demand-based financial crises. A quantitative evaluation shows our model is consistent with the main stylized facts of financial crashes in emerging markets.

Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows, and Exchange Rates? by Harald Hau and Hélène Rey. Published in volume 94, issue 2, pages 126-133 of American Economic Review, May 2004

We explore the implications of a country's external constraint for the dynamics of net foreign assets, returns, and exchange rates. Deteriorations in external accounts imply future trade surpluses (trade channel) or excess returns on the net foreign portfolio (valuation channel). Using a new data set on U.S. gross external positions, we find that stabilizing valuation effects contribute 27 percent of the cyclical external adjustment. Our approach has asset-pricing implications: external imbalances predict net foreign portfolio returns one quarter to two years ahead and net export growth at longer horizons. The exchange rate is forecastable in and out of sample at one quarter and beyond.