A Credit-Based Theory of the Currency Risk Premium

Abstract

This paper extends Kremens and Martin (2019) and uncovers a novel component for exchange rate predictability based on the price difference between sovereign credit default swaps denominated in different currencies. This new forecasting variable – the credit-implied risk premium – captures the expected currency depreciation conditional on a severe but rare credit event. Using data for 16 Eurozone countries, we find that the credit-implied risk premium positively forecasts the dollar-euro exchange rate return at various horizons, both in-sample and out-of-sample. A currency strategy that exploits the informative content of our predictor, moreover, generates substantial out-of-sample economic value.

Keywords: exchange rate, predictability, risk premium, credit risk, sovereign default

JEL Classification: F31, F37, F47, G12, G15