A risk-driven approach to exchange rate modelling

The paper presents a new approach to exchange rate modelling that augments the CHEER model with a sovereign credit default risk as perceived by financial investors making their decisions. In the cointegrated VAR system with nine variables comprised of the short- and long-term interest rates in Poland and the euro area, inflation rates, CDS indices and the zloty/euro exchange rate, four long-run relationships were found. Two of them link term spreads with inflation rates, the third one describes the exchange rate and the fourth one explains the inflation rate in Poland. Transmission of shocks was analysed by common stochastic trends. The estimation results were used to calculate the zloty/euro equilibrium exchange rate.

► We augment the CHEER model by the souvereign credit default premiums. ► The exchange rate of zloty vs. euro is driven by inflation, interest rates and CDSs. ► The cumulated shocks to exchange rate and CDS's push the system in the long-run. ► The exchange rate deviates about 20% from its equilibrium level at peak value.