Do Credit Default Swaps Predict Currency Values?

Abstract

Using daily data of four currencies (Japanese yen, euro, British pound, and Australian dollar) in terms of the U.S. dollar, and these four currencies in terms of the euro from January 2004 to February 2008, we examine the lead-lag relationship between the credit default swap (CDS) market and the currency market. Results indicate significant Granger-causality effects flowing from changes in both the North American investment-grade (IG) and high-yield (HY) CDS indices to changes in the Japanese yen, euro, and Australian dollar exchange rates in terms of the U.S. dollar for the whole period and during the credit crisis of 2007-2008. However, for the four currencies in terms of the euro, significant Granger-causality of the credit risk, measured by iTraxx Europe, is found only for the Australian dollar. Our results indicate that changes in CDS index spreads signal important carry trade information for some currencies, but not others.

Keywords: Credit default Swaps, foreign exchange rates, lead-lag relationship, carry trade

JEL Classification: C22, G14, G15, F31