International Investors, Exchange Rates and Equity Prices

The correlation between equity returns and currency returns affects the risk of international equity portfolios. We analyze the equity index and currency returns of 53 countries and find that correlations are mainly positive. Negative correlations are found for currencies which play a special role in the global financial system like the US dollar, the Japanese yen, the British pound, the euro and the Swiss franc. Correlations generally increased in recent years and are often larger in extreme equity market conditions. In addition, empirical evidence for an equilibrium relationship between equity returns and currency returns - Uncovered Equity Parity - is only found for a small group of countries. For the majority of countries exchange rates increase the risk of international equity portfolios.