A Credit-Based Theory of the Currency Risk Premium

69 Pages Posted: 3 Jul 2019

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: July 2, 2019

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

Suggested Citation

Della Corte, Pasquale and Jeanneret, Alexandre and Patelli, Ella, A Credit-Based Theory of the Currency Risk Premium (July 2, 2019). 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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