Essays on the Currency Effect on Stock Market Relationships and Stock Return Forecast

Asset price movements play credible role as leading indicator for activity, financial distress and general economic wellbeing, and as such, are closely monitored by investors and policymakers alike. All assets’ prices are expressed in a unit of account, usually the home currency of the jurisdiction in which the asset is domiciled, and the values of these currencies continually vary, depending on the balance of demand and supply. The continuous variation in the value of currencies suggests that, at best, they can only be an inappropriate unit of measure of an asset. This dissertation aims to shed more light on why single currencies are inaccurate units of measure of asset prices. Our first study investigates how the currency of valuation affects the outcome of the return and volatility spillovers between the stock market and the foreign exchange (FX) market. Evidence from our study suggests the presence of exchange rate premium in asset prices, which in turn significantly affects the nature of the relationship between the equity and FX markets when asset prices are measured in an aggregate unit of account rather than pair-wise or single currency. In our second study, we examine the currency effect on the predictability of stock returns in the short term. Although previous studies have concentrated on investigating the factors or models that best predict asset returns, our study investigates the effect of currency of valuation on stock return predictability. Our results suggest that reducing the volatility of the variables by valuing them in an aggregate unit of account improves the predictability of stock returns on the short horizon. Our last study investigates the currency effect on the long-term relationship between the stock market and macroeconomic variables. Our results show evidence of significant changes in the relations between the stock market and macroeconomic variables with the introduction of the aggregate currency factor, marked by reducing the effect of the aggregate currency-denominated US macroeconomic variables on the aggregate currency-denominated stock index. Moreover, the results show that the previously documented relations between the stock market and macroeconomic variables, without accounting for the influence of the currency of valuation, might not necessarily hold when the currency factor is discounted