Currency Total Return Swaps: Valuation and Risk Factor Analysis

Abstract

Currency total return swaps (CTRS) are hybrid derivatives instruments that allow to simultaneously hedge against credit and currency risks. We develop a structural credit risk model to evaluate CTRS premia. Empirical test on a sample of 23,005 price observations from 59 underlying issuers yields an average percentage error of around 10%. This indicates that, beyond interest rate risk, firm-specific factors are major drivers of the variations in the valuation of these instruments. Regression analysis of residuals shows that exchange rate determinants account for up to 40% of model pricing errors - indicating that a currency risk premium affects the CTRS price significantly but only marginally, which confirms the prevalence of credit risk in the pricing of CTRS.

Keywords: Credit derivative, credit risk, currency risk

JEL Classification: G13, G15, G32