What do Stock Markets Tell Us About Exchange Rates

The Uncovered Equity Parity (UEP) condition states that countries with stockmarkets that are expected to perform strongly should experience exchange ratedepreciation. We test this condition in a cross-section of 43 countries and .ndthat movements in exchange rates hardly respond at all to stock market develop-ments, suggesting a systematic violation of UEP. We .nd that a trading strategythat invests in countries with the largest expected equity returns and that shortsthose with the smallest generates substantial excess returns and Sharpe ratios.Most, but not all, of these returns are due to compensation for risk.