DP10685 What Do Stock Markets Tell Us About Exchange Rates?

Author(s): Gino Cenedese, Richard Payne, Lucio Sarno, Giorgio Valente
Publication Date: July 2015
Keyword(s): Empirical Asset Pricing, Exchange Rates, International Asset Allocation
JEL(s): F31, G15
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10685

The sign of the correlation between equity returns and exchange rate returns can be positive or negative in theory. Using data for a broad set of 42 countries, we find that exchange rate movements are in fact unrelated to differentials in country-level equity returns. Consequently, a trading strategy that invests in countries with the highest expected equity returns and shorts those with the lowest generates substantial returns and Sharpe ratios. These returns partially reflect compensation for global equity volatility risk, but significant excess returns remain after controlling for exposure to standard risk factors.