The Equity Differential Factor in Currency Markets
Financial Analysts Journal, Forthcoming
14 Pages Posted: 29 May 2019 Last revised: 30 Dec 2019
Date Written: April 29, 2019
We show that the differential in trailing equity market performance across countries strongly predicts the cross section of currency returns. Specifically, exchange rates tend to appreciate for countries that have had the strongest equity returns in the preceding year. Implementable portfolios formed on this equity differential factor generated a return-to-risk ratio superior to the traditional carry, trend, and valuation-reversion factors in currencies since 1990. The equity differential factor cannot be explained by these traditional strategies, and produces a statistically significant alpha in excess of them. Moreover, the factor has performed remarkably consistently over time, including in recent years, and it is robust to many different formulations. We conjecture that marginal investor demand for outperforming equity markets might contribute to this effect.
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