conducted between countries. This definition need not represent the true proportions of a country's exchange rate exposure. To check the sensitivity of our result, we look at the alternative measures of exchange rate risk mentioned previously.
The first measure is an average of the exchange rate returns on two of the major exchange rates. The exchange rates utilized for each currency are given in Table 5.2. For the US dollar portfolios, we equal-weight the exchange rates of the British pound and German mark. The other measure is to use the two exchange rates separately as the independent variable. Defining the exchange rate factor this way will isolate the effect of changes in specific exchange rates on credit returns.
The results for the equal-weighted index are similar to the results for the tradeweighted index. With the equal-weighted measure we find no significant exchange rate exposure at the short and medium horizons. The long-horizon results are similar, with eleven portfolios having significant coefficients as compared to the thirteen for the trade-weighted index. This result is not unexpected because the two major exchange rates account for over 50 per cent of the weight in the trade-weighted index.
The results for our second measure of exchange rate exposure are also similar to the previous results. We find little significance except at the short and medium horizons. At the one-year horizon, we find a positive relationship between credit returns and exchange rates except for the French franc and British pound portfolios.
The conclusion we draw from these data is that exchange rates are not related to credit returns for the short and medium horizons. This result is consistent across the currency portfolios, time-horizons, and exchange rate measures. We can infer that exchange rate risk would not be priced given that the factor loadings are not significantly different from zero. At the longest horizon, one year, we find some evidence of exchange rate changes being related to credit returns. To determine whether this is priced risk would be a difficult task given that the one-year-horizon portfolios have only 186 weekly observations, all of which are overlapping.
One possible explanation is that our credit returns are a noisy estimate of the true process owing to the inherent poor quality of individual corporate bond data. However, by forming portfolios, we have attempted to diversify any random errors (owing to stale quotations, bid--ask effects, etc.) inherent in the raw bond price data.
This chapter looks at the risk exposures of credit returns in the international corporate bond market. Corporate bond returns are affected by riskless interest rate and default factors. We define the credit return as the return on a corporate bond less the return on an equivalent default-free bond. The credit return is interpreted as compensation for bearing default risk.
One potential factor affecting credit returns is exchange rates, both in their potential effects on companies' cash flows and in the market required rate of return. This factor gains importance in light of the European Monetary Union process, since monetary