A credit-based theory of the currency risk premium

Pasquale Della Corte, Alexandre Jeanneret and Ella D.S. Patelli

Journal of Financial Economics, 2023, vol. 149, issue 3, 473-496

Abstract: This paper 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 naïve random walk benchmark.

Keywords: Exchange rate; Predictability; Risk premium; Credit risk; Sovereign default (search for similar items in EconPapers)
Date: 2023
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:149:y:2023:i:3:p:473-496

DOI: 10.1016/j.jfineco.2023.06.002

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