Recently completed research, conducted by academics at Cass Business
School with colleagues from the Bank
of England and the City University of Hong Kong, examines whether
international equity investors can make money from using simple rules to
allocate their cash across national stock markets. In addition the research
looks at whether exchange rate movements tend to systematically reduce the
returns from these international equity investments.
International equity investors attempt to make money by betting on the
performance of national stock markets. A US investor, for example, might buy
Japanese stocks hoping to profit from an increase in Japanese share prices.
There are at least two sources of potential risk associated with this. There is
the obvious risk associated with stock market movements. A drop in the market
could leave the investor facing the possibility of a loss on their Japanese
stock investment. A second source of risk is associated with exchange rates.
The US investor measures their investment performance in US dollars. Movements
in the US dollar to Japanese Yen exchange rate will affect measurements of
dollar performance. For example, if the US investor's Japanese stock holdings
do not change in value but that the price of Japanese yen expressed in US
dollars falls, the US investor's return on his investment will be negative
(even though the individual Japanese stocks have not changed in price).
The research found that average returns of up to 12% per annum are available
to those allocating assets across international stock markets using simple
momentum and value rules. These substantial returns are not specific to any
particular set of countries or any particular time period (although the annual
returns were larger before the 2008 financial crisis).
Regarding the risk posed by movements in exchange rates, the research
demonstrates that, on average, such movements do not erode the profits that
investors can earn from predicatable movements in international stock markets.
This leaves significant returns available to investors allocating money across
global stock markets when returns are measured in an investor's home currency.
It also means that predictable movements in stock markets are of no use in
predicting exchange rate movements.
The work goes on to show that the returns available to international
investors cannot be wholly explained as compensation for bearing stock market
or currency market risk and are not explained away by transaction costs. The
strategy's returns are also uncorrelated with those from existing, well-known
international investment strategies (e.g. FX carry) and thus may provide a nice
complement to international portfolios based on those traditional lines.
To address the questions raised in this study, the researchers used a broad
data set covering more than 40 markets observed over 30 years.
The research is published as a Bank of England working paper, a CEPR
discussion paper and is forthcoming in the Review of Finance.
The Bank of England working paper version is available here
Staff Working Paper No. 537 What do stock markets tell
us about exchange rates?
The CEPR discussion paper can be found here
DP10685 What do stock markets tell us about exchange