Theory and Evidence on the Dynamic Interactions between Sovereign Credit Default Swaps and Currency Options

31 Pages Posted: 20 Jun 2005

See all articles by Liuren Wu

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business

Peter Carr

New York University Finance and Risk Engineering

Date Written: February 7, 2006

Abstract

Using sovereign CDS spreads and currency option data for Mexico and Brazil, we document that CDS spreads covary with both the currency option implied volatility and the slope of the implied volatility curve in moneyness. We propose a joint valuation framework, in which currency return variance and sovereign default intensity follow a bivariate diffusion with contemporaneous correlation. Estimation shows that default intensity is much more persistent than currency return variance. The market price estimates on the two risk factors also explain the well-documented evidence that historical average default probabilities are lower than those implied from credit spreads.

Keywords: Currency options, sovereign credit default swaps, default arrival rate, return variance dynamics, credit spread term structure modeling, option pricing, time-changed Levy process.

JEL Classification: F34, G12, G13.

Suggested Citation

Wu, Liuren and Carr, Peter P., Theory and Evidence on the Dynamic Interactions between Sovereign Credit Default Swaps and Currency Options (February 7, 2006). Available at SSRN: https://ssrn.com/abstract=745824 or http://dx.doi.org/10.2139/ssrn.745824

Liuren Wu (Contact Author)

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
Box B10-247
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)

HOME PAGE: http://faculty.baruch.cuny.edu/lwu/

Peter P. Carr

New York University Finance and Risk Engineering ( email )

6 MetroTech Center
Brooklyn, NY 11201
United States
9176217733 (Phone)

HOME PAGE: http://engineering.nyu.edu/people/peter-paul-carr

Register to save articles to
your library

Register

Paper statistics

Downloads
503
Abstract Views
2,366
rank
54,363
PlumX Metrics