Sovereign Credit Risk and Exchange Rates: Evidence from CDS Quanto Spreads

Abstract

Sovereign CDS quanto spreads-the difference between CDS premiums denominated in U.S. dollars and a foreign currency-tell us how financial markets view the interaction between a country's likelihood of default and associated currency devaluations (the Twin Ds). A noarbitrage model applied to the term structure of quanto spreads can isolate the interaction between the Twin Ds and gauge the associated risk premiums. We study countries in the Eurozone because their quanto spreads pertain to the same exchange rate and monetary policy, allowing us to link crosssectional variation in their term structures to crosscountry differences in fiscal policies. The ratio of the risk-adjusted to the true default intensities is 2, on average. Conditional on the occurrence of default, the true and risk-adjusted 1-week probabilities of devaluation are 5% and 77%, respectively. The risk premium for the euro devaluation in case of default exceeds the regular currency premium by up to 0.3% per week.

Sovereign Credit and Exchange Rate Risks: Evidence from Asia-Pacific Local Currency Bonds

“…We build on the work of Du and Schreger (2016), who propose a methodology to construct LC credit spreads from foreign currency debt in emerging market economies and apply it to a single maturity (five years). Our analysis is also closely related to Augustin, Chernov, and Song (2018), who study the Twin Ds using LC-and USD-denominated sovereign credit default swaps (CDS) in the euro area. Their analysis is limited to one exchange rate across the different countries and a short sample starting in 2010.…”

CDS, Faiz ve Döviz Kuru Arasındaki Nedensellik İlişkisinin Analizi: Granger Coherence Metodundan Yeni Kanıtlar

“…The authors find a strong relationship between the CDS premium and the exchange rate in one day advance. Augustin et al (2019) further contributed to the relationship between possible default events and currency devaluation. They employed CDS premium in Eurozone by using a no-arbitrage model.…”

“…A growing number of papers can be found in the existing literature studying the linkage between CDS spreads and exchange rate movements (see e.g. Augustin et al, 2019;Forte and Pena, 2009;and Foroni et al, 2018). Of these empirical papers, Forte and Pena (2009) studied the relation between CDS and the stock market and bond spread while Aizenman et al (2013) examined the linkage between CDS and inflation and external debt.…”

“…There are several crucial factors behind the movement of the CDS premium. For example, exchange rate fluctuations are closely linked with default events in the case of currency devaluation (Augustin et al, 2019), and extreme currency movements are thought to be one of the main reasons behind sovereign credit risk movement (Foroni et al, 2018). The theory of the relation of the CDS-exchange rate is explained by Zhang et al (2010).…”

The term structure of sovereign credit default swap and the cross‐section of exchange rate predictability

“…Our paper, by contrast, adopts a cross‐sectional methodology and looks at the predictability at higher frequency (monthly). Another related paper is Augustin et al (2018) who analyze the relationship between sovereign credit risk and foreign exchange markets by using sovereign quanto spreads. Although they focus on the interaction between the sovereign default and currency devaluation, they do not consider in their setting the exchange rate predictability.…”