Carry Trades and Sovereign CDS Spreads: Evidence from Asia‐Pacific Markets

Abstract

This article extends the current literature on currency carry trades by investigating the first and second moment interactions between carry trade returns and changes in sovereign credit default swap spreads. Using a VAR-EGARCH model and a sample of nine Asia-Pacific currencies, we examine the relation between sovereign spreads and carry trade returns with and without the inclusion of the 2008 global financial crisis period. Our results show that carry trade returns and sovereign spread changes are negatively correlated, with Granger causality running in both directions. We also find significant volatility spillover effects. High conditional correlation between the currency component of carry trades and sovereign spreads is documented, which is amplified if the crisis period is considered. Global risk affects carry trade volatility more during turbulent periods.

Exchange Rate Dynamics and US Dollar-Denominated Sovereign Bond Prices in Emerging Markets

“…1 Pavlova and de Boyrie (2015) find information flows between currency carry-trade returns of nine economies in the Asia and Pacific and changes in the Markit iTraxx SovX Asia Pacific index from 2008 to 2011, which are negatively correlated.…”

Exchange Rate Dynamics and United States Dollar-Denominated Sovereign Bond Prices in Emerging Markets

“…Their results suggest that currency option volatilities may have served as a proxy for the fundamental macroeconomic and event risks embodied in the CBOE Volatility Index (VIX). 1 Pavlova and de Boyrie (2015) find information flows between currency carry-trade returns of nine economies in the Asia and Pacific and changes in the Markit iTraxx SovX Asia Pacific index from 2008 to 2011, which are negatively correlated. 2 While sovereign risk and exchange rate stability have been studied in the context of sovereign debt crises, the literature on the empirical determinants of sovereign bond yield spreads usually focus on variables other than exchange rates.…”

Credit default swaps and firm risk

“…Zhao and Zhu (2020) study the externalities of CDS on stock return synchronicity. Da Fonseca and Gottschalk (2013), Pavlova and de Boyrie (2015), and Procasky and Yin (2022) study the interaction between CDS and options, foreign exchange (FX), and stock markets, respectively. We extend their studies to the firm risk and provide a reflection on how changes in derivative securities and markets influence research (Webb, 2022).…”