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A credit-based theory of the currency risk premium

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

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.

Suggested Citation

  • Della Corte, Pasquale & Jeanneret, Alexandre & Patelli, Ella D.S., 2023. "A credit-based theory of the currency risk premium," Journal of Financial Economics, Elsevier, vol. 149(3), pages 473-496.
    • Handle: RePEc:eee:jfinec:v:149:y:2023:i:3:p:473-496
    DOI: 10.1016/j.jfineco.2023.06.002
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