Currency total return swaps: valuation and risk factor analysis

Romain Cuchet, Pascal François and Georges Hübner

Quantitative Finance, 2013, vol. 13, issue 7, 1135-1148

Abstract: Currency total return swaps (CTRS) are hybrid derivative instruments that allow us to simultaneously hedge against credit and currency risks. We develop a structural credit risk model to evaluate CTRS premia. An empirical test on a sample of 23,005 price observations from 59 underlying issuers yields an average percentage error of around 10%. This indicates that, beyond interest rate risk, firm-specific factors are major drivers of the variations in the valuation of these instruments. Regression analysis of residuals shows that exchange rate determinants account for up to 40% of model pricing errors, indicating that a currency risk premium affects the CTRS price significantly but only marginally, which confirms the prevalence of credit risk in the pricing of CTRS.

Date: 2013
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Working Paper: Currency Total Return Swaps: Valuation and Risk Factor Analysis (2011)
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DOI: 10.1080/14697688.2013.775475

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