Portfolio Reallocation and Exchange Rate Dynamics

Exchange rate is quoted by dealers based on the order flow they receive. Market survey and FX market microstructure literature suggest that financial customers order flow is the most informative and leads total order flow. This paper explains exchange rate dynamics by linking financial customers FX order flow with their dynamic portfolio allocation among domestic and foreign assets. Specifically, for any currency pair in a particular period, one currency has relatively higher assets return than the other and can be considered as high-return currency (HRC). Profit-seeking financial customers would hold more (less) HRC assets if their returns are expected to increase (decrease). Such portfolio reallocation generates positive (negative) order flow for the HRC and the currency appreciates (depreciates). Meanwhile, holding HRC assets is risky because of exchange rate fluctuations and higher volatility associated with high-return assets. Everything else equal, when financial customers become more risk-loving (risk-aversion), they would hold more (less) HRC assets, which causes positive (negative) order flow toward the HRC and the currency appreciates (depreciates). Thus, value of high-return currency (low-return currency) is positively (negatively) driven by expected returns of HRC assets and investors' risk appetite. The entire exchange rate dynamics is thus based directly on the financial market structure as opposed to traditional macroeconomic variables. As switch can occur in HRC status, business cycle and dominating factor, the direction that related financial variables affect exchange rate varies in different regimes. The paper finds country-specific period-specific supportive evidence for all major currencies in a long time period