A Credit-Based Theory of the Currency Risk Premium
117 Pages Posted: 3 Jul 2019 Last revised: 16 Aug 2021
Date Written: August 8, 2021
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. Moreover, a currency strategy that exploits the informative content of our predictor generates substantial out-of-sample economic value against the naive random walk benchmark.
Keywords: exchange rate, predictability, risk premium, credit risk, sovereign default
JEL Classification: F31, F37, F47, G12, G15
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