Private information, stock markets, and exchange rates

February 2009

Abstract

Explaining exchange rates has long been an important but vexing issue in international economics and finance. In recent years, a number of studies have shown that investors' private information plays a central role in determining exchange rates. We demonstrate in this paper that the exchange rate-relevant private information of investors is largely centered on the stock market, and that this information is conveyed to FX markets by portfolio capital flows that are induced by investors' transactions in the stock market. We do so by analyzing novel and so-far unused datasets on nearly two years' worth of daily-frequency capital flows of nonresident investors in the foreign exchange, stock, and bond markets of Thailand. We present compelling evidence that portfolio capital flows which are induced by nonresident investors transactions in the Stock Exchange of Thailand - which we show are driven largely by private information - have far greater explanatory power for the exchange rate than other portfolio capital flows have, both in the short run and the long run. In contrast, portfolio capital flows of nonresident investors that are related to their transactions in Thai government bonds - which we find are not driven appreciably by private information - do not have a statistically significant effect on the exchange rate.