Working Paper: CEPR ID: DP16058
Authors: Pasquale Della Corte; Lucio Sarno; Maik Schmeling; Christian Wagner
Abstract: 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. The relation between currency excess returns and sovereign risk is mainly driven by defaultexpectations (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 Codes: F31; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increase in sovereign risk (CDS spreads) (F34) | Depreciation of currency (F31) |
| Increase in sovereign risk (CDS spreads) (F34) | Increase in currency volatility (F31) |
| Sovereign risk factor (F34) | Pricing in cross-section of currency returns (F31) |
| Lagged CDS spreads (E49) | Future currency excess returns (F31) |
| Global sovereign risk (F34) | Currency excess returns (F31) |
| Local sovereign risk (F34) | Currency excess returns (F31) |