Uncovered Return Parity: Equity Returns and Currency Returns

Abstract: We propose an uncovered expected returns parity (URP) condition for the bilateral spot exchange rate that results from free entry into international finance by global financiers. Under URP, bilateral spot exchange rates are realizations of two underlying parity conditions that depend, in part, on the expected returns of risky assets available to financiers. We estimate finite mixture model regressions for six currencies against the US dollar (Australia, Canada, Japan, Norway, Switzerland and the UK) and show that expected excess equity returns are a statistically significant determinant of exchange rate dynamics. We subject our results to numerous robustness exercises and find consistent evidence of the importance of expected excess equity returns for exchange rate dynamics.