A Credit-Based Theory of the Currency Risk Premium

86 Pages Posted: 3 Jul 2019 Last revised: 25 Jun 2020

See all articles by Pasquale Della Corte

Pasquale Della Corte

Imperial College Business School; Centre for Economic Policy Research (CEPR)

Alexandre Jeanneret

HEC Montréal

Ella Patelli

HEC Montréal

Date Written: June 24, 2020

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

Suggested Citation

Della Corte, Pasquale and Jeanneret, Alexandre and Patelli, Ella, A Credit-Based Theory of the Currency Risk Premium (June 24, 2020). Available at SSRN: https://ssrn.com/abstract=3413785 or http://dx.doi.org/10.2139/ssrn.3413785

Pasquale Della Corte

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London, SW7 2AZ
United Kingdom
+44(0)20 759 49331 (Phone)

HOME PAGE: http://sites.google.com/view/pasqualedellacorte

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Alexandre Jeanneret (Contact Author)

HEC Montréal ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada

HOME PAGE: http://www.alexandrejeanneret.net

Ella Patelli

HEC Montréal ( email )

3000, Chemin de la Côte-Sainte-Catherine
Montreal, Quebec H2X 2L3
Canada

HOME PAGE: http://www.elladspatelli.com/

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