Real financial market exchange rates and capital flows

Foreign exchange rates, asset prices and capital movements are expected to be closely related to each other as international capital markets become more and more integrated. This paper provides new empirical evidence from an index of exchange-rate adjusted cross-country asset price ratios, which may be interpreted as a real effective financial exchange rate. The integrated stock-flow approach reveals that a country's real effective financial exchange rate is cointegrated with international investors' net foreign holdings of its assets. The associated error correction equations have useful interpretations against the backdrop of uncovered return parity and investor portfolio rebalancing behavior. •We construct an index of exchange-rate adjusted cross-country stock price ratios.•This index is cointegrated with domestic shares held by international investors.•Error correction behavior implies a moderate speed of adjustment of asset prices.•At the same time, international investors rebalance their portfolio shares.