Exchange Rates and Sovereign Risk

Abstract

An increase in a country’s sovereign risk, as measured by credit default swap spreads, is accompanied by a contemporaneous depreciation of its currency and an increase of its volatility. The relation between currency excess returns and sovereign risk is mainly driven by default expectations (rather than distress risk premia) and exposure to global sovereign risk shocks and also emerges in a predictive setting for currency risk premia. We show that a sovereign risk factor is priced in the cross-section of currency returns and that it is not subsumed by the carry factor. This paper was accepted by David Simchi-Levi, finance.

Exchange Rate Sensitivity and the Net Foreign Asset Composition

“…Moreover, Della Corte et al. (2018) show that global sovereign credit risk, as measured by credit default swap spreads, is also related to exchange rate movements. The results in Table O.A.3 show that global CDS spread changes have a large general effect, and that the higher credit risk is also associated with a stronger depreciation of the currencies with large net debt liabilities, and especially in the private sector.…”

Sovereign credit and exchange rate risks: Evidence from Asia-Pacific local currency bonds

“…While they emphasize this interaction between currency and credit risk, they do not formally jointly model bond yields, exchange rates and credit risk or their drivers. Della-Corte, Sarno, Schmeling, and Wagner (2016) empirically show that the common component in sovereign credit risk correlates with currency depreciations and predicts currency risk premia. Buraschi, Sener, and Menguetuerk (2014) suggest that geographical funding frictions may be responsible for persistent mispricing of emerging market bonds denominated in EUR and USD.…”

Towards an early warning system for sovereign defaults leveraging on machine learning methodologies

“…In this study, we opt to use financial variables, such as exchange rates against the US dollar, rather than market variables, like CDS, mainly due to the lack of historical data in the selected sample. However, this is not considered a drawback, as according to the empirical work of Della Corte et al (2021), there is a strong systematic link between exchange rates and sovereign CDS, which is used to measure a country's sovereign risk.…”