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Title: Currency Total Return Swaps: Valuation and Risk Factor Analysis
Authors: Cuchet, Romain
François, Pascal
Hübner, Georges
Keywords: Credit derivative
Credit risk
Currency risk
Issue Date: 2011-09
Series/Report no.: Cahiers du CIRPÉE;11-28
Abstract: Currency total return swaps (CTRS) are hybrid derivatives instruments that allow to simultaneously hedge against credit and currency risks. We develop a structural credit risk model to evaluate CTRS premia. 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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