Sovereign Credit Risk and Exchange Rates: Evidence from CDS Quanto Spreads
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.
We thank Nelson Camanho, Peter Hoerdahl, Alexandre Jeanneret, Francis Longstaff, Guillaume Roussellet, Lukas Schmid, Jesse Schreger, Gustavo Schwenkler, and Andrea Vedolin for comments on earlier drafts and participants in the seminars and conferences sponsored by the 2018 Financial Intermediation Research Conference, the 2018 SFS Cavalcade, the 15th IDC Herzliya Annual Conference in Financial Economics, the Bank of France, Duke-UNC 2018, HEC Paris, Hong Kong Monetary Authority, McGill, Penn State, the Swedish House of Finance, UCLA. Augustin acknowledges financial support from the Fonds de Recherche du Québec - Société et Culture grant 2016-NP-191430. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Patrick Augustin & Mikhail Chernov & Dongho Song, 2019. "Sovereign credit risk and exchange rates: Evidence from CDS quanto spreads," Journal of Financial Economics, .