Essays on exchange rate risk

Chapter 1: This paper estimates the expected impact of sovereign default on the local currency. Using credit default swaps denominated in both local currency and US dollar for each sovereign, I find that investors expect currencies to generally depreciate upon default. I also show that the Euro is expected to depreciate by more against the US dollar upon some defaults (Germany, France) than others (Greece, Ireland). Additionally, using a dataset of historical defaults, I find that currencies have depreciated in nominal and real terms. I examine the ability of two widely used models to generate depreciation upon default. Contrary to historical data, the standard complete markets model predicts real appreciation upon default. However, a segmented markets model can generate real and nominal depreciation upon default if inflation and default occur simultaneously.;Chapter 2: We decompose the covariance of currency returns with forward premia into a cross-currency, a between time and currency, and a cross-time component. The surprising result of our decomposition is that the cross-currency and cross-time-components account for almost all systematic variation in expected currency returns, while the between time and currency component is statistically and economically insignificant. This finding has three of surprising implications for models of currency risk premia. First, it shows that the two most famous anomalies in international currency markets, the carry trade and the Forward Premium Puzzle (FPP), are separate phenomena that may require separate explanations. The carry trade is driven by persistent differences in currency risk premia across countries, while the FPP appears to be driven by time-series variation in all currency risk premia against the US dollar. Second, it shows that both the carry trade and the FPP are puzzles about asymmetries in the risk characteristics of countries. The carry trade results from persistent differences in the risk characteristics of individual countries; the FPP is the result of time variation in the average return of all currencies against the US dollar. As a result, existing models in which two symmetric countries interact in financial markets cannot explain either of the two anomalies.