Journal of Financial Economics Vol. 149 No. 3 2023
A credit-based theory of the currency risk premium
open access
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.
- DOI
- 10.1016/j.jfineco.2023.06.002
- Volume
- 149
- Issue
- 3
- Pages
- 473-496
- Language
- en
- Sources
- bibtex:phds-export.bib openalex crossref