A Credit-Based Theory of the Currency Risk Premium

Abstract

This paper extends the work of Kremens and Martin (2019) and uncovers a novel component for exchange rate predictability. Our theory shows that currency returns compensate investors for the expected currency depreciation in the case of a severe but rare credit event. We compute this risk compensation - the credit-implied risk premium (CRP) - by exploiting the price difference between sovereign credit default swaps denominated in different currencies. Using data for 16 Eurozone countries over the period 2010-17, we find that CRP positively forecasts the euro-dollar exchange rate return between one-week and six-month horizon, both in-sample and out-of-sample. We also show that currency trading strategies that exploit the informative content of CRP generate substantial out-of-sample economic value.

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

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