Multi-currency Risky Sovereign Bonds Arbitrage (Part V)

Posted: 4 Nov 2013 Last revised: 30 Apr 2015

Vilimir Yordanov


Date Written: April 15, 2015


Emerging markets sovereigns are active issuers both of foreign and domestic debt. The former is composed mainly of internationally traded Eurobonds denominated in foreign hard currency and provides a direct benchmark for the creditworthiness of the country. However, in the last years, there started to be a large interest in the latter too. Both asset managers and investment banks considered the domestic treasuries a special asset class that provides good opportunities for diversification and extra returns. They reflect not only the credit risk of the sovereign, but also a whole set of additional risk factors such as the exchange rate, inflation, and recovery rate. This complexity requires a proper no-arbitrage approach so that the two types of debt are priced consistently. We build such from scratch in a Heath-Jarrow-Morton setting and derive explicitly the necessary no-arbitrage conditions. We allow for jumps in the exchange rate and the interest rate of the risky country at the time of default. Further, we consider the diffusions driving the exchange rate, interest rates, and the intensity of default to be correlated. This captures consistently the intrinsic dependency between the macro aggregates. We make an empirical application to an exhaustive set of emerging market countries in a novel PCA affine setting based on the recent advances there. With many emerging market sovereigns issuing also inflation indexed bonds, special analysis is devoted to deriving the respective no-arbitrage conditions and also to providing relevant supporting empirics. Finally, employing everything done so far, we discuss issues related to optimal asset allocation across multi-currency sovereign bonds.

Keywords: arbitrage, term structure, HJM, foreign debt, local currency debt, credit spread, currency spread, affine setting, exchange rate, inflation

JEL Classification: F30, E43, G12, G15, C58

Suggested Citation

Yordanov, Vilimir, Multi-currency Risky Sovereign Bonds Arbitrage (Part V) (April 15, 2015). Available at SSRN:

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