DP16058 Exchange Rates and Sovereign Risk

Author(s): Pasquale Della Corte, Lucio Sarno, Maik Schmeling, Christian Wagner
Publication Date: April 2021
Keyword(s): CDS spreads, Currency options, currency risk premium, Exchange Rates, sovereign risk
JEL(s): F31, G12, G15
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16058

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 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.