Working Paper: CEPR ID: DP10685
Authors: Gino Cenedese; Richard Payne; Lucio Sarno; Giorgio Valente
Abstract: 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.
Keywords: Empirical Asset Pricing; Exchange Rates; International Asset Allocation
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| foreign exchange (FX) exposure hedging (F31) | negative correlation between equity returns and currency returns (G15) |
| return-chasing behavior (C92) | positive correlation between equity returns and currency returns (G15) |
| expected future equity returns (G17) | substantial returns from trading strategy (G17) |
| exchange rate changes (F31) | little information about equity return differentials (G12) |
| exchange rate component of total dollar return (F31) | close to zero (C60) |