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Exchange Rates and Sovereign Risk

Author

Listed:
  • Sarno, Lucio
  • Della Corte, Pasquale
  • Schmeling, Maik
  • Wagner, Christian

Abstract

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.

Suggested Citation

  • Sarno, Lucio & Della Corte, Pasquale & Schmeling, Maik & Wagner, Christian, 2021. "Exchange Rates and Sovereign Risk," CEPR Discussion Papers 16058, Centre for Economic Policy Research.
    • Handle: RePEc:cpr:ceprdp:16058
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    2. Min Su & Yixuan Ren & Yifang Niu & Zhen Wang, 2025. "Dynamic linkages and determinants of sovereign CDS and exchange rates: evidence from G7 and BRICS," Humanities and Social Sciences Communications, Palgrave Macmillan, vol. 12(1), pages 1-13, December.
    3. Albrecht, Peter & Kočenda, Evžen, 2025. "Event-driven changes in volatility connectedness in global forex markets," Journal of Multinational Financial Management, Elsevier, vol. 77(C).
    4. Kočenda, Evžen & Albrecht, Peter & Pastorek, Daniel, 2025. "Geopolitical risk and extreme spillovers among oil-based energy commodities," Energy Economics, Elsevier, vol. 152(C).
    5. Geyikçi, Utku Bora & Özyıldırım, Süheyla, 2023. "Deviations from covered interest parity in the emerging markets after the global financial crisis," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 85(C).
    6. Reinhold Heinlein & Gabriella D. Legrenzi & Scott M. R. Mahadeo & Gabriella Deborah Legrenzi, 2024. "Exchange Rates and Sovereign Risk: A Nonlinear Approach Based on Local Gaussian Correlations," CESifo Working Paper Series 11019, CESifo.
    7. Ghulam, Yaseen, 2025. "A further examination of sovereign domestic and external debt defaults," The North American Journal of Economics and Finance, Elsevier, vol. 76(C).
    8. Longaric, Pablo Anaya & Cera, Katharina & Georgiadis, Georgios & Kaufmann, Christoph, 2025. "Investment funds and euro disaster risk," Working Paper Series 3029, European Central Bank.
    9. Masaru Tsuruta, 2024. "Interaction between Sovereign Quanto Credit Default Swap Spreads and Currency Options," JRFM, MDPI, vol. 17(2), pages 1-33, February.
    10. Pasquale Della Corte & Aleksejs Krecetovs, 2024. "Current Account Uncertainty and Currency Premia," Management Science, INFORMS, vol. 70(9), pages 5795-5815, September.
    11. Mohamed M. Sraieb & Shahnawaz Muhammed & Vladimir Dženopoljac & Samet Gunay, 2025. "Determinants of Russia’s probability of default: evidence from domestic and global indicators," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 49(3), pages 854-882, September.
    12. Iwanaga, Yasuhiro & Sakemoto, Ryuta, 2025. "Conditional currency momentum portfolios," International Review of Financial Analysis, Elsevier, vol. 99(C).
    13. Kun Yang & Ruxin Deng & Yunjie Wei & Shouyang Wang, 2025. "The power of ChatGPT in processing text: Evidence from analysis and prediction in the exchange rate markets," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 11(1), pages 1-33, December.
    14. Jorge M. Uribe & Oscar Valencia, 2024. "Taking the Pulse of Fiscal Distress: Inflation, Depreciation, and Crises," IREA Working Papers 202416, University of Barcelona, Research Institute of Applied Economics, revised Dec 2024.
    15. Jiang, Yong & Klein, Tony & Ren, Yi-Shuai & Dai, Jia-Hang, 2025. "Through the looking glass: Unveiling geopolitical risks and sovereign bond spillovers in the eurozone," International Review of Financial Analysis, Elsevier, vol. 103(C).
    16. Della Corte, Pasquale & Jeanneret, Alexandre & Patelli, Ella D.S., 2023. "A credit-based theory of the currency risk premium," Journal of Financial Economics, Elsevier, vol. 149(3), pages 473-496.
    17. Giraldo, Carlos & Giraldo, Iader & Gomez-Gonzalez, Jose E. & Uribe, Jorge M., 2024. "Term spread spillovers to Latin America and emergence of the ‘Twin Ds’," International Review of Economics & Finance, Elsevier, vol. 96(PB).
    18. Calice, Giovanni & Lin, Ming-Tsung, 2024. "Sovereign momentum currency returns," International Review of Financial Analysis, Elsevier, vol. 96(PB).
    19. Laurinaityte, Nora & Meinerding, Christoph & Schlag, Christian & Thimme, Julian, 2024. "GMM weighting matrices in cross-sectional asset pricing tests," Journal of Banking & Finance, Elsevier, vol. 162(C).
    20. Randl, Otto & Simion, Giorgia & Zechner, Josef, 2025. "Pricing and constructing international government bond portfolios," Journal of Financial Economics, Elsevier, vol. 173(C).

    More about this item

    Keywords

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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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