Sovereign credit risk and exchange rates: Evidence from CDS quanto spreads

Authors: Patrick Augustin, Mikhail Chernov and Dongho Song

Publication: Journal of Financial Economics, Forthcoming

Abstract:

Sovereign CDS quanto spreads tell us how financial markets view the interaction between a country’s likelihood of default and associated currency devaluations (the Twin Ds). A no-arbitrage model applied to the term structure of Eurozone quanto spreads can isolate the Twin Ds and gauge the associated risk premiums. Conditional on the occurrence of default, the true and risk-adjusted 1-week probabilities of devaluation are 42% (2%) and 90% (55%) for the core (periphery) countries. The weekly risk premium for Euro devaluation in case of default for the core (periphery) exceeds the regular currency premium by up to 18 (13) basis points.

Desautels 22

In recognition of research excellence as it relates to publications in top-tier management journals, our Faculty has compiled a list of high quality, peer-reviewed management journals, which is referred to as the Desautels 22.