Foreign Currency Forecasting: What Can Stock and Bond Markets Tell Us?

Abstract

This paper provides the first comprehensive investigation on the informational role of financial markets in the profitable predictability of exchange rates in an out-of-sample (OOS) context. Within a comparative analysis framework across developed and emerging countries, we examine if international stock and bond returns can be exploited as a predictor for future exchange rate changes (statistical test), and if an economically profitable trading strategy can be executed (economic test). Our central finding is that currency traders can beat emerging markets conditional on correctly predicting the direction of the OOS forecasted currency returns induced by emerging stock and, to a lesser extent, bond market returns. By contrast, this profitability is not visible in developed countries data. This asymmetric evidence, on the power of stock and bond returns in the profitable predictability of currency returns across developed and emerging countries, provides several important insights to researchers and practitioners alike

Keywords: exchange rates, out of sample predictability, Equity Returns, bond market returns