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A Credit-Based Theory of the Currency Risk Premium

Last Updated on 10 February, 2024 by Rejaul Karim

The paper “A Credit-Based Theory of the Currency Risk Premium” by Pasquale Della Corte, Alexandre Jeanneret, and Ella Patelli presents an innovative perspective by introducing a novel element for exchange rate predictability derived from the price disparity between sovereign credit default swaps denominated in different currencies.

This newly unveiled forecasting variable, termed the credit-implied risk premium, effectively captures the anticipated currency depreciation under conditions of a severe yet infrequent credit event. Through an in-depth analysis encompassing data from 16 Eurozone countries, the study establishes the credit-implied risk premium as a robust predictor that positively forecasts the dollar-euro exchange rate return across various time horizons.

Furthermore, the implementation of a currency strategy leveraging the informative nature of this predictive variable demonstrates substantial out-of-sample economic value, outperforming the simplistic random walk benchmark.

This research not only advances our understanding of exchange rate predictability but also introduces a pioneering dimension to the evaluation of risk premium, credit risk, and sovereign default in the realm of currency dynamics.

Abstract Of Paper

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.

Original paper – Download PDF

Here you can download the PDF and original paper of A Credit-Based Theory of the Currency Risk Premium.

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Author

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

Alexandre Jeanneret
UNSW Business School

Ella Patelli
UBC – Sauder School of Business

Conclusion

In conclusion, “A Credit-Based Theory of the Currency Risk Premium” by Pasquale Della Corte, Alexandre Jeanneret, and Ella Patelli, showcases the substantial advancement in the realm of exchange rate predictability through the introduction of the novel credit-implied risk premium.

The paper’s extension of Kremens and Martin’s research effectively reveals this newly identified forecasting variable as a robust predictor that positively forecasts the dollar-euro exchange rate return at various time horizons.

The implementation of a currency strategy leveraging the informative content of this predictor further underscores its capability to generate substantial out-of-sample economic value, outperforming the simplistic random walk benchmark.

This groundbreaking study not only deepens our comprehension of exchange rate predictability but also presents a cutting-edge perspective on risk premium and sovereign default in the context of currency dynamics. Its contributions promise to significantly influence future analyses and strategies in finance, shaping a more informed and effective approach to understanding currency dynamics and risk management.

Related Reading:

Foreign Exchange Risk and the Predictability of Carry Trade Returns

Empirical Evidence on the Currency Carry Trade, 1900-2012

FAQ

Q1: What is the novel element introduced in the paper “A Credit-Based Theory of the Currency Risk Premium” for exchange rate predictability, and how does it contribute to our understanding of currency dynamics?

A1: The novel element introduced in the paper is the credit-implied risk premium, derived from the price disparity between sovereign credit default swaps denominated in different currencies. This new forecasting variable captures the expected currency depreciation conditional on a severe but rare credit event. The study establishes the credit-implied risk premium as a robust predictor that positively forecasts the dollar-euro exchange rate return across various time horizons, contributing to a deeper understanding of exchange rate predictability.

Q2: How does the credit-implied risk premium perform in forecasting the dollar-euro exchange rate return, and what economic value does it provide in an out-of-sample context?

A2: The credit-implied risk premium is found to positively forecast the dollar-euro exchange rate return at various horizons, indicating its effectiveness as a predictor. The paper demonstrates that a currency strategy leveraging the informative content of this predictor generates substantial out-of-sample economic value. This strategy outperforms the naive random walk benchmark, highlighting the practical implications of incorporating the credit-implied risk premium in currency forecasting and trading.

Q3: What are the implications of this research for risk premium evaluation, credit risk, and sovereign default in the context of currency dynamics?

A3: The research introduces a pioneering dimension to the evaluation of risk premium, credit risk, and sovereign default in currency dynamics through the credit-implied risk premium. By uncovering a novel component for exchange rate predictability, the study advances our understanding of the interplay between credit events and currency movements. The implications extend to risk management and decision-making in the financial markets, offering new insights into the relationships between credit dynamics and currency risk premiums.

You can find many more Research Papers here

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