Default expectations and currency movements

Pasquale Della Corte, Lucio Sarno, Maik Schmeling, Christian Wagner 17 May 2021



Sovereign defaults are often associated with severe currency devaluations and heightened uncertainty about exchange rates (e.g. Reinhart 2002, Reinhart and Rogoff 2009). This fact, usually investigated for pegged currencies, builds on the notion that governments cannot maintain a fixed or stable exchange rate regime when it is inconsistent with the state of the economy (Goldstein and Razin 2013).

However, the mechanism that connects sovereign default and exchange rate fluctuations also seems applicable to freely floating currencies. Riskier currencies must compensate investors willing to hold them, and indeed a series of papers provides evidence of priced risk premia in currency markets (e.g. Lustig et al. 2011, Menkhoff et al. 2012, Lettau et al. 2013, Della Corte et al. 2016). Also, if investors believe that sovereign default becomes more likely in a country, they demand higher spreads, which increases the debt level and the likelihood of default itself (Bacchetta et al. 2015). Yet, little evidence is available on how currency risk relates to sovereign risk, one of the most prominent sources of risk for international financial markets. This is surprising given the historical evidence cited earlier, which would imply that expectations about the likelihood of sovereign default (i.e. sovereign risk) and the potential for contagion effects that typically accompany sovereign default in a country should affect the risk premium that international investors demand for holding foreign currencies. 

Building on this insight, our recent research in Della Corte et al. (2021) tests whether returns in foreign exchange (FX) markets are related to sovereign risk. Their results show that an increase in a country's sovereign risk, quantified by credit default swap spreads, is accompanied by a contemporaneous depreciation of its currency and a surge in its volatility. This result holds across countries with different exchange rate regimes, different stages of development, and different levels of liquidity of their currency markets. 

The result in one picture

Anecdotal evidence can illustrate our main result: Consider the period preceding the widely anticipated UK credit rating downgrade on 22 February 2013. Figure 1 shows that starting from 1 December 2012, the spread on the five-year UK government credit default swap (CDS) increased from 31 to 52 basis points. A credit default swap contract allows investors to buy protection against the event of a sovereign default at a market price, which is the credit default swap spread. During the same period, the pound (GBP) depreciated by more than 5% against the US dollar (USD). In derivatives markets, investors positioned against the GBP, with net speculator positions (observed in Commodity Futures Trading Commission data) changing from about 30,000 contracts long to 30,000 contracts short. The implied volatilities of USD/GBP options surged, and more so for put relative to call options, reflecting the market's perception of tail risks and increased cost of crash insurance. Notably, the downgrade was only one notch down from AAA, so the UK was far away from actually defaulting on its debt.

Figure 1 The pound-dollar exchange rate and UK sovereign risk

While the UK downgrade in 2013 is simply an illustrative example based on a particular episode, there exists empirically a robust systematic relationship between currency excess returns and sovereign risk both across countries and over time. Natural follow-up questions are where this effect comes from and what it means, which we turn to next.  

What do we learn?

A country's sovereign risk can be measured using the spread of its sovereign credit default swap, which reflects both the state of the local and global economy as well as investor risk aversion. It can then be decomposed into the market's default expectations and distress risk premia demanded by investors for facing unpredictable variation in market spreads (e.g. Longstaff et al. 2011). 

Regression analysis is conducted for a broad set of (up to 40) currencies against the US dollar between January 2003 and July 2017, uncovering several important findings. 

First, the currencies of countries that experience increasing sovereign risk show a significant contemporaneous depreciation. In regressions of currency excess returns on changes in sovereign credit default swap spreads, both for individual countries and different pools of countries, the slope coefficient is significantly negative at the daily, weekly, and monthly frequency. This relation is particularly strong for countries with floating exchange rates and/or open capital accounts. For example, in a pooled regression for floating currencies at the monthly frequency, the R-squared is as large as 21%. This figure is orders of magnitude higher than the very low explanatory power typically recorded in similar regressions that use, for example, (changes in) interest rate differentials. Moreover, the economic effect across countries is also large: A 100 basis points increase in the (per annum) credit default swap spread over a month is associated with an exchange rate depreciation of approximately 5.65% over the same month. 

What exactly drives the relation between exchange rates and sovereign risk?

Credit default swap spreads can be decomposed into global and local components. In doing so, one can show that the contemporaneous link to currency excess returns is mainly driven by changes in global sovereign risk, whereas local sovereign risk is much less important. Moreover, global sovereign risk contains currency-relevant information that is not captured by commonly used global variables, namely, the VIX index, US stock markets, US high-yield bond spreads, and commodity markets. This analysis shows that different currencies have different sensitivities to global sovereign risk. Moreover, in Della Corte et al. (2021) we provide empirical evidence for a cross-sectional relation of these exposures to macroeconomic fundamentals linked to government debt financing, including external asset-liability positions, the currency composition of foreign debt, inflation rate, and interest rate level (see Figure 2). This evidence lends support to the notion that sovereign risk captures fundamental information that is relevant to currency markets. 

Figure 2 Correlation between exposure to global sovereign risk and macro variables

To further dig into the root cause of the findings, one can also decompose credit default swap spreads into default expectations and distress risk premia. Doing this reveals that the nexus between sovereign risk and currency movements is mostly driven by changes in default expectations and that distress risk premia play a minor role. This means that default expectations embedded in sovereign credit default swap spreads are an important state variable for exchange rates, and this mechanism is not confined to defaulting countries nor to fixed exchange rate regimes.

Is this useful to forecast and/or trade exchange rates out of sample?

The results described above indicate a strong contemporaneous relationship between sovereign default expectations and currency movements, in line with the notion that default expectations are an important state variable and that shocks to this state variable are priced in currency markets. However, these results are also important for forecasting and trading currencies. Indeed, our research paper moves to testing whether default expectations matter for risk premia in the cross-section of currencies in a predictive, rather than contemporaneous, setting. This is shown by building currency portfolios sorted by sovereign risk, which are found to forecast excess returns to trading foreign exchange forwards, foreign exchange volatility, and to some extent foreign exchange skewness (using foreign exchange options data). In short, portfolios sorted by sovereign credit default swap spreads display strong predictive power: long-short portfolio strategies generate significantly positive currency excess returns as well as excess returns to selling volatility in foreign exchange option markets, with economically sizeable Sharpe ratios.

A risk-factor based on global sovereign risk

This motivates further analysis that explores whether lagged credit default swap spreads are also related to future currency excess returns and whether sovereign risk is a priced factor in currency markets. Using traditional asset pricing tests, the evidence suggests that a credit default swap-based sovereign risk factor is priced in a broad cross-section of currency and foreign exchange option returns that includes both credit default swap-sorted portfolios as well as popular currency strategies like carry trade and momentum.

Concluding remarks

The evidence discussed here makes a compelling case that sovereign risk is important for the cross-section of expected currency movements. Exchange rate movements – and hence excess returns on currency investments – strongly comove with changes in sovereign risk. The variation in credit default swap spreads across countries forecasts excess returns to trading currencies using foreign exchange forward contracts and options strategies. Notably, the relationship between currency excess returns and sovereign credit default swap spreads is mostly driven by countries' exposures to global sovereign risk. In contrast, local sovereign risk turns out to be less important. The exposure of a country's exchange rate to movements in global sovereign risk co-varies with conventional measures of a country's vulnerability to external shocks (external position, foreign debt, inflation, etc.) Moreover, decomposing sovereign risk into different components related to default expectations and distress risk premia, the link between exchange rates and sovereign risk is mainly attributable to default expectations. Overall, sovereign risk appears to be an important source of risk in currency markets that has often been neglected in the context of countries with floating exchange rates in previous literature.


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Della Corte, P, L Sarno, M Schmeling and C Wagner (2021), “Exchange rates and sovereign risk”, CEPR Discussion Paper 16058; Management Science, forthcoming.

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Topics:  Exchange rates Financial markets

Tags:  sovereign default, exchange rates, risk premium, volatility, sovereign risk, credit default swap

Associate Professor of Finance at Imperial College Business School, Imperial College London; CEPR Research Affiliate

Professor of Finance, Cambridge Judge Business School, University of Cambridge

Professor of Finance, Goethe University Frankfurt

Professor of Finance, WU Vienna University of Economics and Business

CEPR Policy Research