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Keywords:

  • exchange rates;
  • Markov switching;
  • capital flows;
  • Sharpe ratio

ABSTRACT

In this paper, I investigate the effects of cross-border capital flows induced by the rate of risk-adjusted excess returns (Sharpe ratio) on the transitional dynamics of the nominal exchange rate's deviation from its fundamental value. For this purpose, a two-state time-varying transition probability Markov regime-switching process is added to the sticky price exchange rate model with shares. I estimated this model using quarterly data on the four most active floating rate currencies for the years 1973–2009: the Australian dollar, Canadian dollar, Japanese yen and the British pound. The results provide evidence that the Sharpe ratios of debt and equity investments influence the evolution of transitional dynamics of the currencies' deviation from their fundamental values. In addition, I found that the relationship between economic fundamentals and the nominal exchange rates vary depending on the overvaluation or undervaluation of the currencies. Copyright © 2011 John Wiley & Sons, Ltd.