Saturday, March 27, 2021

Using equity returns to forecast cross-section currency returns


All markets are connected around the globe. These connections are based on price differentials and flows. Money will flow to those places where higher returns can be generated. If there are higher returns in the equity markets of one country over another, capital will flow to that country's equity market. The corresponding flows will impact currency markets because the flows will increase currency demand and drive exchange rates higher. These exchange rate adjustments will, of course, impact overall returns. A recent paper looked at the link between equity market returns and cross-sectional currency returns and finds a strong positive relationship. See "The Equity Differential Factor in Currency Markets" by Turkington and Yazdani in the Financial Analysts Journal second quarter 2020

Currency market seem to be predictable cross-sectionally with carry, trend, and valuations factors all generating positive returns for ranked long/short portfolios. The authors found that ranking 12 month equity returns can form an equity differential strategy similar to carry. The strategy is not based on buying the underlying equities but using equity returns as two possible signals. One, the higher equity returns may signal  higher economic growth. Two, the higher equity returns lead to higher relative demand which requires the purchase of the spot currency. Many, however, have viewed that causality moves from exchange rates to equity markets, but this study given the lag relationships shows the causality moving from equities to currencies. 

Using a long sample from 1990 through 2017, the authors find that the equity return differential does a very good job of creating currency portfolios that generate positive returns across a broad set of currency pairs in the G10. The portfolio is a netted set of currency pairs and not just a ranking approach for the 10 currencies against the dollar. A similar approach is used for carry, trend and value as a comparison. The equity differential actually generates the best return to risk ratio. While producing slightly less return versus carry, the equity differential portfolio does not generate the negative skew found in the carry factor portfolio.

Using equity return differentials can be another method of trading currencies and show the strong return and capital flow link across all financial markets. 

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