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Currency total return swaps: valuation and risk factor analysis


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.

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Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

Volume (Year): 13 (2013)
Issue (Month): 7 (February)
Pages: 1135-1148

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Handle: RePEc:taf:quantf:v:13:y:2013:i:7:p:1135-1148
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  1. Ericsson, Jan & Jacobs, Kris & Oviedo-Helfenberger, Rodolfo, 2004. "The Determinants of Credit Default Swap Premia," SIFR Research Report Series 32, Institute for Financial Research.
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  7. Duan, Jin-Chuan & Simonato, Jean-Guy, 1999. " Estimating and Testing Exponential-Affine Term Structure Models by Kalman Filter," Review of Quantitative Finance and Accounting, Springer, vol. 13(2), pages 111-35, September.
  8. Skinner, Frank S. & Townend, Timothy G., 2002. "An empirical analysis of credit default swaps," International Review of Financial Analysis, Elsevier, vol. 11(3), pages 297-309.
  9. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
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