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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. JEL classification numbers: C32, E31, E43Keywords: exchange rate modelling, sovereign credit default risk, CDS spread, international parities, equilibrium exchange rate * We are particularly grateful to Janusz Zieliński and Piotr Matczuk from the National Bank of Poland for providing us with the CDS series and stimulating the discussions. Any errors are the sole responsibility of the authors.

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