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

Abstract

We provide novel evidence on exchange rate predictability by using the term premia of the sovereign credit default swap (CDS). Using a sample of 29 countries, we find that the sovereign CDS term premia significantly predict the exchange rates out‐of‐sample. On average, a steeper CDS spread curve for a country predicts its currency appreciation against the U.S. dollar (USD). Empirically, although the sovereign CDS level mainly reflects global risk, the information in the term premia of the sovereign CDS spreads reveals country‐specific risk. Notably, the predictive power of the term premia is robust after controlling for the sovereign CDS level and other conventional global macroeconomic and financial factors. Further analysis shows that the information in the sovereign CDS term premia is also helpful for forecasting international stock market returns.

US macroeconomic surprises and the emerging‐market sovereign CDS market

“…can predict currency appreciation against the US dollar (Calice & Zeng, 2021) that significantly explains quarterly real GDP growth (Augustin, 2018). Our study contributes to the literature on the SCDS spread slope by providing informational content to reflect on the stock markets of emerging economies.…”

“…In analyzing a sample of 29 countries, Calice and Zeng (2021) calculate the slope of the SCDS spreads as the log difference between 10‐ and 1‐year SCDS spreads. Their empirical results demonstrate that countries with a steeper term structure could predict their currency appreciation against the US dollar.…”

“…Third, knowing the role of the slope of the SCDS spread is important because it contains more information on different short‐term and long‐term expectations. A steeper slope for the SCDS term structure is associated with higher long‐term or lower short‐term expectations and can predict currency appreciation against the US dollar (Calice & Zeng, 2021) that significantly explains quarterly real GDP growth (Augustin, 2018). Our study contributes to the literature on the SCDS spread slope by providing informational content to reflect on the stock markets of emerging economies.…”

“…4 Please see Pan and Singleton (2008), Attinasi et al (2009), Longstaff et al (2011), Kalbaska and Gątkowski (2012), Pu and Zhang (2012), Aizeman e al. ( 2013), Chiarella et al (2015), Clark and Kassimatis (2015), Kim et al (2015), Augustin (2018) and Calice and Zeng (2021). 5 Kim et al (2015) use a 5-year sample of 19 countries to analyze the impact on SCDS spreads arising from macroeconomic news from the United States, Eurozone countries and China.…”

Sovereign CDS and mutual funds: Global evidence

“…As such, sovereign CDS are the subject of a growing body of research examining their impact on other financial markets. This includes government bonds (Calice et al, 2013;Fontana and Scheicher, 2016;Dockner et al, 2017), foreign exchange market (Foroni et al, 2018;Calice and Zeng., 2019;Dooley and Hutchison, 2009), currency options (Hui and Fong, 2011), equity markets (Ngene et al, 2014;Sun et al, 2020) and commodity markets (Sun et al, 2020). We build upon this prior body of work which examines whether the news contained in the change of sovereign CDS spread is informative about other markets and extend it to examine the case of mutual fund returns and subsequent flows to mutual funds.…”