Abstract:
Relying on the uncovered equity parity (UEP), we formulate a predictive model that links movements in exchange rate to stock return differential between the domestic market and the foreign (US) market. We also test for any probable asymmetric relationship between the two variables while also accounting for the role of observed common (global) factor such as oil price. We find a positive relationship between stock return differential and exchange rate return for three of the BRICS countries namely Brazil, India and South Africa, thus validating the UEP hypothesis, whereas a contrasting evidence is observed for China and Russia. We further establish the out-of-sample predictability of stock return differential for exchange rates of the BRICS while accounting for the role of observed common (global) factor, and asymmetry may further improve the forecast accuracy. The implications of our findings for portfolio diversification and foreign exchange management are highlighted.
