union would eliminate exchange rate risk. If a risk premium does exist for exchange rate risk, than a benefit of monetary union would be the potential elimination of the associated risk premium in companies' borrowing costs.
We examine whether credit returns are related to foreign exchange changes after controlling for other sources of systematic risk. The relationship between credit returns and the different risk factors is explored at different holding-period horizons. We first examine the systematic factors which affect credit returns. The factors we choose are related to interest rates, stock market returns, and exchange rates. We assume a linear pricing relation between credit returns and the above factors. Regressions are performed to determine which factors are significantly related to credit returns. The resulting factor loadings are inputs to an unconditional multivariate asset pricing model.
The results show a significant negative relationship between credit returns and the term spread. The slope of the term structure is found to be significant at the longest horizon while the excess stock market factor is weakly significant across currencies and horizons. The results show that credit returns are affected by interest rates and to a lesser extent by excess stock returns.
We find that credit returns of corporate bonds are not related to exchange rates at short to medium horizons. This result is consistent across currencies. The results for the longest horizon, one year, show evidence of a significant relationship between exchange rates and credit returns. We check to see whether this result is robust to the definition of the exchange rate factor. We analyse two alternative exchange rate factors and find similar results to the trade-weighted index factor.
The conclusion we draw is that there is a negligible relationship between credit returns and exchange rates for short or medium horizons. Only at the longest horizon studied is there some evidence of exchange rates affecting credit returns. Although whether this risk is priced remains an open question, given their small exposure, the impact of currency union on the borrowing costs of companies will most likely be small.
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