Do stock markets have predictive content for exchange rate movements?

Abstract

This paper examines short‐horizon exchange rate predictability and investigates whether stock returns contain information for forecasting daily exchange rate movements. Inspired by the uncovered equity parity condition, we show that stock return differentials have in‐sample and out‐of‐sample predictive power for nominal exchange rates with short horizons (1‐day‐ahead predictions). That is, stock markets inform us about exchange rate movements, at least in the case of high‐frequency data.

Stock markets and exchange rate behavior of the BRICS

“…Like the RMSE statistics, the C–T statistics seem to increase with the consideration of the mentioned control variable (oil price movements) and asymmetry effect in the stock differential series. This outcome is in line with the evidence of Chen and Hsu (2019) albeit with a focus on most traded currencies and without considering asymmetry effect. An extension of the Chen and Hsu (2019) study to capture the emerging markets of the BRICS offers is crucial for possible generalization of the predictability of stock markets for exchange rates.…”

“…As the domestic stock market offers higher expected returns, a domestic investor suffers a loss when investing abroad and therefore should be compensated by the expected capital gain that occurs when the foreign currency appreciates (Chen & Hsu, 2019). However, beyond the fact that the coefficient on Russian exchange rate is not statistically significant (although, correctly signed), the predictability results for the Chinese yuan tend to contradict the UEP prediction, but the results yet find support in Griffin et al (2004); Hau and Rey (2006); Malliaropulos, 2008; Wong and Li (2013); Chabot et al (2014), Ülkü et al (2016), and Chen and Hsu (2019). This contrasting evidence to the UEP hypothesis can be attributed to return chasing behavior of investors, whereby investors decide to increase their holdings in market that have recently outperformed other markets.…”

“…5 5 In any case, expressing the series in return form helps to circumvent the problem of unit root typical of most financial series expressed in price index form. Note that we also follow Chen and Hsu (2019) in this regard.…”

“…The parameter γ is the differential intercept coefficient and it is used to determine if the average exchange rate return differs between positive and negative changes in stock differential. For robustness, we also account for a global factor, oil price, in the model (see Chen & Hsu, 2019; Ferraro et al, 2015; Salisu et al, 2019; Salisu et al, 2020) and thus, we are able to evaluate the sensitivity of the relationship between stock differential and exchange rate to control variables.…”

“…This rebalancing usually results in the selling of foreign currency thus leading to foreign currency depreciation. In the context of UEP, a positive association is hypothesized between stock return differentials and exchange rate because a weak currency is associated with a strong equity market due to portfolio rebalancing (Chen & Hsu, 2019). Some empirical studies have offered evidence in support of the UEP (i.e., positive correlation between the two variables in question) (see Cappiello & De Santis, 2005, 2007; Chen & Hsu, 2019; Curcuru et al, 2014; Gelman et al, 2015; Hau & Rey, 2006; Kim, 2011) while there is also evidence of a negative correlation (see Bohn & Tesar, 1996; Cenedese et al, 2016; Chabot et al, 2014; Chen & Hsu, 2019; Griffin et al, 2004; Malliaropulos, 2008; Ülkü et al, 2016; Wong & Li, 2013).…”