Price Cointegration between Sovereign CDS and Currency Option Markets in the Financial Crises of 2007-2013

17 Pages Posted: 1 Jan 2012 Last revised: 21 Dec 2015

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Tom Fong

Hong Kong Monetary Authority

Date Written: December 17, 2015

Abstract

The sovereign credit default swap (CDS) spreads and exchange rates of the developed economies including the US, Japan, Switzerland and the eurozone with the first three countries' currencies conventionally considered as safe-haven varied in a wide range during the financial crises since late 2007. This raises the question of any interconnectivity between the anticipated sovereign credit risks of these economies and the market expectations of their exchange rates. Using a bivariate vector error-correction model with random coefficients, this paper finds evidence of cointegration and time varying conditional correlation between the prices in the sovereign CDS and currency option markets. This suggests that the relative sovereign credit risk of these developed economies impacts the market expectations of their exchange rates in the long run, but in the short run the impact changes drastically in times of crisis, resulting in drastic and persistent price deviations from their long-run equilibrium amid central banks' monetary measures and market turbulence.

Keywords: Sovereign Risk, Currency Options, Credit Default Swaps, Cointegration

JEL Classification: F31, G13

Suggested Citation

Hui, Cho-Hoi and Fong, Tom, Price Cointegration between Sovereign CDS and Currency Option Markets in the Financial Crises of 2007-2013 (December 17, 2015). International Review of Economics & Finance, 40 (2015) 174–190. Available at SSRN: https://ssrn.com/abstract=1977376 or http://dx.doi.org/10.2139/ssrn.1977376

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Tom Fong

Hong Kong Monetary Authority ( email )

55/F, Two International Finance Centre, Central
Hong Kong
Hong Kong

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