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Currency Returns, Intrinsic Value, and Institutional-Investor Flows




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    • Froot is André R. Jakurski Professor of Business Administration at Harvard University and is a research fellow and Chairman of the Insurance Program at the NBER; Ramadorai is at the University of Oxford and CEPR. We thank an anonymous referee, Mark Aguiar, Atindra Barua, John Campbell, Randy Cohen, Frank Diebold, Bernard Dumas, Rich Lyons, Colin Mayer, Paul O'Connell, Andrei Shleifer, Jeremy Stein, Tuomo Vuolteenaho, Joshua White, and especially Jeff Frankel for comments; seminar participants at the Harvard Finance and International Economics Seminars and the NBER Spring IFM Program Meetings for discussions; the Department of Research at Harvard Business School for research support; and State Street Corporation and State Street Associates for data. All errors remain our responsibility. This is a substantially revised version of NBER Working Paper no. 9101.


We decompose currency returns into (permanent) intrinsic-value shocks and (transitory) expected-return shocks. We explore interactions between these shocks, currency returns, and institutional-investor currency flows. Intrinsic-value shocks are: dwarfed by expected-return shocks (yet currency returns overreact to them); unrelated to flows (although expected-return shocks correlate with flows); and related positively to forecasted cumulated-interest differentials. These results suggest flows are related to short-term currency returns, while fundamentals better explain long-term returns and values. They also rationalize the long-observed poor performance of exchange-rate models: by ignoring the distinction between permanent and transitory exchange-rate changes, prior tests obscure the connection between currencies and fundamentals.