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Get free live currency rates, tools, and analysis using the most accurate data. The latest FX news and analysis, live currency rates, forex calendar and more. From a simple asset pricing viewpoint, it is straightforward to show that the correlation between exchange rates and equity returns can take any sign; the sign depends on the covariance between returns and currency and stock market risk premia. Recent theory notably Hau and Rey suggests that foreign exchange and equity market returns should be negatively correlated because of portfolio rebalancing.
To see the mechanism, consider a US portfolio manager with money invested in Japan. When the Japanese stock market rises relative to the US, the manager is overweight with Japanese equities and, to return to a neutral position, sells Japanese stock and then sells the Japanese yen proceeds for US dollars. The sale of yen for dollars causes the yen to depreciate at the same time that the Japanese stock market is outperforming. This is the essence of the uncovered equity parity UEP condition whose statistical validity is assessed in various studies e.
Hau and Rey , Melvis and Prins and the references therein. We look again at this correlation, but from the cross-sectional perspective that is typical in empirical finance research. We consider an investor who builds a portfolio strategy designed to capture differences in future predicted returns across international equity markets in local currency, without hedging foreign exchange risk at all.
We measure the returns from this strategy, and how they decompose into an equity market and foreign exchange component.
This allows us to evaluate the economic importance of the uncovered equity parity deviations directly, and also measure the correlation between equity and currency returns in a broad cross-section of countries. Our analysis is based on data for over 40 country-level equity indices observed over the past 30 years.
In line with a vast literature on stock market predictability, we make forecasts of individual stock market returns using conventional predictors, such as aggregate dividend yields, momentum returns, and yield curve term spreads.
The portfolio strategy we consider goes long markets that are predicted to rise and short markets that are predicted to fall or to rise less. Figure 1 shows the cumulative returns from the strategy that predicts stock market returns using momentum returns. Clearly, in this case, currency returns are not working against investors. After providing evidence on the economic significance of the correlation between foreign exchange and stock market returns, we explore the logical question of whether the large positive returns from our portfolio strategy are merely a compensation for bearing risk.
Using techniques that are routinely implemented in cross-sectional asset-pricing studies, we show that the average volatility of international stock markets prices the cross-section of returns from our international strategy fairly well. Portfolios that generate high expected returns do so partly because they tend to pay off when global stock volatility is low, and they perform poorly when global stock volatility is high.
However, we also show that exposure to global stock market volatility does not tell the full story for our cross-section of stock market returns. If there is a relationship between stock market and currency returns, this should be searched for at individual country level, and the above results do not rule out that the correlation may not be zero or vary over time for certain countries or in response to specific shocks.
However, on average, across a broad set of countries, their correlation is essentially zero. This article is published in collaboration with VoxEU.