INTERNATIONAL STOCK RETURN DIFFERENTIALS AND REAL EXCHANGE-RATE CHANGES

This article investigates the link between international stock return differentials relative to the US and deviations from relative Purchasi ng Power Parity. Assuming that the real exchange rate and the relative stock price between two countries contain both permanent and temporar y components, we are able to derive a relationship between expected st ock return differentials between the same two countries and expected c hanges in the real exchange rate in terms of observables. The predicti ons of the model are tested empirically using stock market indices of four major OECD countries relative to the US. The empirical results in dicate that there is a negative relationship between stock return diff erentials against the US and changes in the real exchange rate, i.e. s tock markets outperform the US stock market in countries where the cur rency appreciates in real terms against the dollar. (C) 1998 Elsevier Science Ltd. All rights reserved.