Moving beyond uncovered interest rate parity to uncovered return parity

The failure of uncovered interest rate parity is one of the most well-documented puzzles of international finance and the driver of currency carry trades. Carry is one of the main factors explaining cross-sectional currency returns along with trend and value; however, research has also focused on the link between currency and country asset returns in general, not just interest differentials. We have posted on differential equity returns as another factor explaining currency returns. See, Using equity returns to forecast cross-section currency returns.

Two economists with the Bank of Canada have developed a more general approach for measuring expected exchange rate changes through a concept they call uncovered return parity. See, Uncovered Return Parity: Equity Returns and Currency Returns. Under this model, uncovered interest rate parity is a special case of uncovered return parity. 

In this approach, the expected exchange rate change is related to the both the relative interest rate and equity returns. Both of these will impact currency flows and hedging. An exchange rate change will be a mixture of responses to both rate and equity return patterns. This more general approach will actually explain the impact of commodity shocks that can be seen from oil because oil price changes will impact equity returns for many countries. Commodity prices impact capital returns and flows. 

The authors test their uncovered return parity model through OLS regression and through a finite mixture model (FMM). While the coefficients are not always the same, the importance of the equity factor is clear when tested with the interest rate differential.   

For investors in currencies, looking at the relative trends in equity returns can support relative value trades in the currency space.