A Credit-Based Theory of the Currency Risk Premium (working paper) - PDF version
With Pasquale Della Corte and Alexandre Jeanneret
Abstract : This paper extends the work of Kremens and Martin (2019) and uncovers a novel component for exchange rate predictability. 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.
Uncertainty and equity valuation: implications from learning about firm profitability (work in progress)
Abstract : This paper explores how uncertainty affects equity valuation. We develop a model in which investors learn about firms’ profitability based on analysts forecasts. The forecasts are affected by two sources of shocks, a systematic and an idiosyncratic shock, that jointly determine stock prices in equilibrium. We show that equity valuation decreases with the systematic component of uncertainty but increases with the idiosyncratic component. We estimate our measures of uncertainty for 2,298 US firms and find that the relative importance of idiosyncratic versus systematic uncertainty can explain why the relation between uncertainty and equity valuation varies strongly across firms.