We develop an equilibrium model in which exchange rates, stock prices, and capital flows are jointly determined under incomplete foreign exchange (forex) risk trading. Incomplete hedging of forex risk, documented for U.S. global mutual funds, induces the following price and capital flow dynamics: Higher returns in the home equity market relative to the foreign equity market are associated with a home currency depreciation. Net equity flows into the foreign market are positively correlated with a foreign currency appreciation. The model predictions are strongly supported at daily, monthly, and quarterly frequencies for 17 OECD countries vis-à -vis the United States. Correlations are strongest after 1990 and for countries with higher equity market capitalization relative to GDP, suggesting that the observed exchange rate dynamics is indeed related to equity market development.The last 25 years have been characterized by a remarkable increase in international capital mobility. While gross cross-border transactions in bond and equity for the United States were equivalent to only 4% of GDP in 1975, this share increased to 100% in the early 1990s and has grown to 245% by 2000. Furthermore, a growing proportion of these capital flows consists of equity as opposed to bank loans or government bonds 1 The Deniz Igan provided outstanding research assistance. We thank Mike Woodford for his comments.

The electronic trading system Xetra of the German Security Exchange provides a unique data source on the equity trades of 756 professional traders located in 23 different cities and eight European countries. We explore informational asymmetries across the trader population: Traders located outside Germany in non-Germanspeaking cities show lower proprietary trading profit. Their underperformance is not only statistically significant, it is also of economically significant magnitude and occurs for the 11 largest German blue-chip stocks. We also examine whether a trader location in Frankfurt as the financial center, or local proximity of the trader to the corporate headquarters of the traded stock, or affiliation with a large financial institution results in superior trading performance. The data provide no evidence for a financial center advantage or of increasing institutional scale economies in proprietary trading. However, we find evidence for an information advantage due to corporate headquarters proximity for high-frequency~intraday! trading.INFORMATION AND ITS PRESUMED ASYMMETRIC distribution has become an important aspect of financial market theory. Yet even though information heterogeneity of agents is now a common assumption in microstructure models, direct evidence for the scope of such asymmetry is hard to provide. 1 Existing theories offer little guidance as to who should be the better-informed investors. Moreover, it has proven difficult to document the existence of any investor group that consistently outperforms the market. For example, professional mutual fund managers appear unable to "beat" the market. 2

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We explore whether the pattern of international equity returns, equity portfolio flows, and exchange rate returns are consistent with the hypothesis that (unhedged) global investors rebalance their portfolio in order to limit their exchange rate exposure when there are (1) relative equity return and (2) exchange rate shocks. We also explore whether (3) equity flow shocks influence the exchange rates and relative equity prices. In the estimation of the VAR system we do not impose any causal ordering upon the primitive shocks, but instead identify the system based on theoretical priors about the contemporaneous conditional correlations between the three variables. International data for the five largest equity markets are consistent with a theory in which equity returns and portfolio rebalancing are an important source of exchange rate dynamics.

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