Exchange Rates and Sovereign Risk
85 Pages Posted: 15 Nov 2013 Last revised: 10 Aug 2018
Date Written: August 9, 2018
An increase in a country's sovereign risk, as measured by credit default swap spreads, is accompanied by a contemporaneous depreciation of its currency and an increase of its volatility and crash risk. The relation between currency excess returns and sovereign risk is mainly driven by default expectations (rather than distress risk premia) and exposure to global sovereign risk shocks, and also emerges in a predictive setting for currency risk premia. We show that a sovereign risk factor is priced in the cross-section of currency returns and that it is not subsumed by the carry factor.
Keywords: Exchange rates, currency risk premium, currency options, sovereign risk, CDS spreads.
JEL Classification: F31, G12, G15
Suggested Citation: Suggested Citation