To simultaneously account for the properties of interest-rate term structure and foreign exchange rates within one arbitrage-free framework, we propose a class of multi-currency quadratic models (MCQM) with an (m + n) factor structure in the pricing kernel of each economy. The m factors model the term structure of interest rates. The n factors capture the portion of the exchange rate movement that is independent of the term structure. Our modeling framework represents the first in the literature that not only explicitly allows independent currency movement, but also guarantees internal consistency across all economies without imposing any artificial constraints on the exchange rate dynamics. We estimate a series of multi-currency quadratic models using U.S. and Japanese LIBOR and swap rates and the exchange rate between the two economies. Estimation shows that independent currency factors are essential in releasing the tension between the currency movement and the term structure of interest rates.

We propose a simple model of credit contagion in which we include macro- and microstructural interdependencies among the debtors within a credit portfolio. The microstructure captures interdependencies between debtors that go beyond their exposure to common factors, e.g., business or legal interdependencies. We show that even for diversified portfolios, moderate microstructural interdependencies have a significant impact on the tails of the loss distribution. This impact increases dramatically for less diversified microstructures.