Multi-currency Sovereign Bonds Arbitrage: A Dynamic Factors Approach

Abstract

Sovereigns are active issuers of both foreign and domestic debt. The former, primarily composed of internationally traded hard currency-denominated Eurobonds, serves as a direct benchmark for the country’s creditworthiness. The latter, represented by local treasuries, is considered a distinct asset class with strong differentiation among reserve currency, developed market, and emerging market issuers. In addition to the domestic natural rate of interest and sovereign credit risk, both debt types are influenced by a range of additional risk factors, including inflation, exchange rate, and recovery rate. This complexity necessitates a robust no-arbitrage term-structure approach to ensure consistent pricing across debt types. We develop such a framework from the ground up within a novel Heath-Jarrow-Morton multi-curve reduced-form setting. We then extend it to a dynamic factor model using a principal-component-based affine approach, building on recent advancements in the riskless single-curve framework. Our empirical analysis covers an extensive set of reserve currency, Eurozone, developed market, and emerging market economies. In addition to their general analytical value, our results provide a basis for relative value analysis, the development of new trading strategies, and the construction of optimal fixed-income portfolios.

Keywords: bonds, credit risk, currency risk, HJM, principal components

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