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Hints for cross-country equity strategies


An academic paper looks at cross-country relative-value equity strategies. It concludes that [i] relative conventional factors might create alpha and [ii] relative local country equity index returns are uncorrelated with currency returns (and hence the two could be independent value creators).

Cenedese, Gino, Richard Payne, Lucio Sarno and Giorgio Valente (2015), “What Do Stock Markets Tell Us About Exchange Rates?” CEPR Discussion Paper No. 1068.
Freely accessible version:

The below are excerpts from the paper. Headings and cursive text have been added.

A simple cross-country relative equity strategy

“A trading strategy that invests in countries with the highest expected equity returns and shorts those with the lowest generates substantial…Sharpe ratios.”

“We use country-level dividend yields, term spreads, and momentum variables as our predictors….

  • Dividends are routinely used as fundamentals to explain equity returns, and predictions based on dividend yields can be seen as a basis for value strategies…Dividend yields are rolling 12-month cumulative dividends scaled by beginning of year price level…
  • The term spread, i.e. the difference between long- and short-term yields, may predict returns because it captures compensation for risk common to all long-term securities….Term spreads are the difference in yields between 10-year government bonds and 3-month bills in each country…
  • We also use a momentum variable in light of the large body of research that has documented that a strategy of buying equities with high recent returns and selling equities with low recent returns results in large average excess returns…We compute momentum-based predictions of future equity returns using trailing cumulative 12-month returns.”

N.B.: The selection bias of factors towards those that had already been identified as useful past predictors means that the paper’s empirical findings are not a realistic backtest.

“Using a sample of 42 countries over a period covering November 1983 to September 2011, we study a trading strategy that goes long markets with the highest expected equity returns and short those with the lowest…

  • We find that this strategy earns an average US-dollar excess return between 7% and 12% per annum, depending on the predictor used to forecast equity returns.
  • The large average returns can be explained, in part, as compensation for risk. Global equity volatility risk has the strongest cross-sectional pricing power. However, risk exposure does not tell the whole story as, while our portfolios have significant exposures to global equity volatility risk, they still provide substantial risk-adjusted returns (alpha) and larger Sharpe ratios than conventional strategies based on US-specific or global factors…
  • We demonstrate that the main conclusions regarding the return generating power of the… strategy are robust to focusing on the most recent decade of data, focusing on a restricted cross-section of countries, including market transactions costs and using returns derived from exchange-traded funds (ETFs) rather than index levels.”

The relation between equity and FX returns

“It is tempting to think of the strategy studied here as the FX carry trade using equities rather than bonds. However, this is not the case because the returns from the…strategy are virtually uncorrelated with the returns from the FX carry trade.”

“The sign of the correlation between equity and FX returns is not clear theoretically…

  • The Uncovered Equity Parity (UEP) condition…argues that, if investors cannot perfectly hedge their FX exposure, when a foreign equity market outperforms domestic equities one will observe a depreciation of the foreign currency due to portfolio rebalancing: when foreign equities outperform, the FX exposure of domestic investors increases, so that they sell some of the foreign equity to reduce FX risk. These sales of foreign currency-denominated assets have a negative impact on the exchange rate…
    On the basics of the uncovered equity parity view post here.
  • An alternative is that the correlation between international equity returns and currency returns is positive as an effect of return-chasing by investors. A large literature shows that investors often increase their holdings in markets that have recently outperformed.”

“We find that exchange rate movements are in fact unrelated to differentials in country-level equity returns…Exchange rate changes do not offset expected equity return differentials, and the evidence is similar to that in the FX carry literature, which finds that exchange rate changes do not offset the profits available from exploiting international interest rate differentials.


Ralph Sueppel is managing director for research and trading strategies at Macrosynergy. He has worked in economics and finance since the early 1990s for investment banks, the European Central Bank, and leading hedge funds.


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