A0946
Title: A credit-based theory of the currency risk premium
Authors: Pasquale Della Corte - Imperial College London (United Kingdom) [presenting]
Alexandre Jeanneret - HEC Montreal (Canada)
Ella Patelli - HEC Montreal (Canada)
Abstract: A novel component for exchange rate predictability is uncovered. Our theory shows that currency returns compensate investors for the expected 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 sovereign credit default swaps denominated in different currencies. Using data for 16 Eurozone countries over the period 2010-17, we find that CRP positively forecasts the euro-dollar exchange rate return between one-week and six-month horizon, both in-sample and out-of-sample. We also show that currency trading strategies that exploit the informative content of CRP generate substantial out-of-sample economic value.
