From Currency Volatilities to Global Equity Correlations

Abstract

We derive and empirically test a theoretical link between exchange rate volatility and global equity correlations. Starting with option-implied currency volatilities, we use variants of existing currency models, global capital flows, international parity, the Taylor rule, and some simplifying assumptions to theoretically link foreign exchange options-implied volatilities and future global equity correlations. Using data from January 1999 to June 2015, we test our hypothesis and find that exchange rate implied volatilities — coupled with one-period ex-post correlations — more accurately predict subsequent equity market correlations than other models. Our findings have implications for portfolio diversification, forecast of overall equity portfolio volatility, and portfolio optimization.