The Exposure of International Corporate Bond Returns to Exchange Rate Risk
GORDON DELIANEDIS AND PEDRO SANTA-CLARA
This chapter looks at the effects of exchange rate variability on corporate bond returns, trying to ascertain the extent to which currency risk impacts the borrowing costs of companies. The relevance of this study becomes apparent in the context of European Monetary Union. In fact, one of the benefits of currency unification that has been touted is the reduction of financing costs to European companies, from decreasing exchange rate risk. This chapter examines the likelihood and extent of these potential gains.
Exchange rate changes may be correlated with corporate bond returns for two reasons: first, because the company's expected future cash flows may depend on exchange rates; secondly, because exchange rates may affect the required market discount rates on these cash flows. This change in the required discount rate can arise from changes in default-free interest rates or from changes in credit risk premia.
In this chapter, we try to isolate the changes in default-free interest rates in corporate bond returns and concentrate on the other sources of returns. With that purpose, we study credit returns, that is the returns on corporate bonds above the returns on risk- free bonds with the same promised payments. Credit returns are particularly interesting owing to the option-like pay-off of corporate bonds.1 Since they just depend on changes in the solvency of the issuing company, credit returns are very sensitive to events that affect the future prospects of the company. Even more so than equity returns.
The riskiness of corporate credit returns has both idiosyncratic and systematic sources. However, only the latter may be priced and are thus of interest to us. Finding no covariation of credit spreads with such factors would be evidence that they are not priced. However, finding some covariation still leaves the question of whether the risk source is priced. We examine potential risk factors such as stock market returns,
Thanks are due to Jean Dermine for helpful comments.