I propose a global risk factor – Currency Traded Risk (CTR). This risk factor is the first to identify the directional link between currencies and equities. CTR captures the genesis of financial globalization, and contains the greatest predictive ability to date for monthly returns on a global stock portfolio.
Theoretically, return expectation is intimately linked to time-varying risk premia. Due to the intrinsic scope of currency values in integrating the world’s financial markets, information on time-varying risk premia prices into currencies at greater speed, scale, and global consensus, relative other asset classes. High interest rate currencies proxy as a risk-on asset class. Low interest rate currencies proxy as a risk-off asset class. Innovations in these currencies’ values summarize global risk premia and forecast equity market returns.
CTR measures two sources of global risk premia; the difference between averaged spot returns of high interest rate currencies and low interest rate currencies, and the difference between implied and realized volatility of high interest rate currencies. Using recursive regressions, CTR predicts monthly MSCI World Index© returns out of sample, with R2’s consistent at 10% from 2008 to 2017. Currencies track global risk premia, whereas equities respond to it.
