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A Credit-Based Theory of the Currency Risk Premium

30 October 2019 at 12:00 PM - 2:00 PM

Room 207, Campus on Viale Romania, 32

Speaker: Pasquale Della Corte , Imperial College

ABSTRACT

This paper extends the work of Kremens and Martin (2019) and uncovers a novel component forexchange rate predictability. Our theory shows that currency returns compensate investors for theexpected 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 sovereigncredit default swaps denominated in different currencies. Using data for 17 Eurozone countries overthe period 2010-19, we find that CRP positively forecasts the euro-dollar exchange rate return betweenone-week and six-month horizon, both in-sample and out-of-sample. We also show that currency tradingstrategies that exploit the informative content of CRP generate substantial out-of-sample economicvalue.

Link al paperhttps://papers.ssrn.com/sol3/papers.cfm?abstract_id=3413785