In pair-wise analyses of a sample of 9 developed and 12 emerging markets, we find evidence that currencies are positively correlated with stocks in emerging countries. We provide evidence that international capital flows based on ‘flight-to-quality’ in down-markets and ‘flight-to-risk’ in up-markets, in conjunction with asymmetrically developed bond markets, may generate these strong ties between the currency and stock returns. This implies that currencies provide a natural hedge for emerging country’s
investors investing in developed countries. Using a unique sample of 27 ‘Siamese Twin’ international mutual fund pairs in Korea, which hold identical underlying foreign assets but offer different currency hedging alternatives, we find evidence that hedging currency risks actually undoes the natural hedge and increase the total return volatility.
