Working Paper: NBER ID: w24506
Authors: Patrick Augustin; Mikhail Chernov; Dongho Song
Abstract: Sovereign CDS quanto spreads—the difference between CDS premiums denominated in U.S. dollars and a foreign currency—tell us how financial markets view the interaction between a country's likelihood of default and associated currency devaluations (the Twin Ds). A noarbitrage model applied to the term structure of quanto spreads can isolate the interaction between the Twin Ds and gauge the associated risk premiums. We study countries in the Eurozone because their quanto spreads pertain to the same exchange rate and monetary policy, allowing us to link cross-sectional variation in their term structures to cross-country differences in fiscal policies. The ratio of the risk-adjusted to the true default intensities is 2, on average. Conditional on the occurrence of default, the true and risk-adjusted 1-week probabilities of devaluation are 5% and 77%, respectively. The risk premium for the euro devaluation in case of default exceeds the regular currency premium by up to 0.3% per week.
Keywords: Sovereign Credit Risk; Exchange Rates; CDS Quanto Spreads
JEL Codes: C1; E43; E44; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Sovereign credit event (F34) | FX rate jump (F31) |
| Sovereign credit event (F34) | Default hazard rate (C41) |
| Sovereign credit event (F34) | Currency devaluation probability (F31) |
| Debt-to-GDP ratio increase (H69) | CDS premiums increase (G22) |
| Default (Y70) | Currency devaluation probability (F31) |
| Sovereign credit event in one country (F34) | Default probabilities in other countries (F29) |