Abstract
The study conducts an empirical test on dollar-denominated sovereign credit spreads in emerging markets, including Brazil, Colombia, Mexico, the Philippines, the Russian Federation, and Turkey to examine their relationship with each country’s exchange rate and the United States (US) Treasury yields. The relationship between each country’s exchange rate and the pricing of each country’s US-dollar denominated sovereign bonds was particularly strong after the global financial crisis of 2008–2009. A two-factor pricing model is developed with closed-form solutions for the sovereign bonds. The correlated factors in the model are foreign exchange rates and US risk-free interest rates that follow a double square-root process relevant in a low interest rate environment. The numerical results and associated error analysis show that the model credit spreads can broadly track market credit spreads.
Highlights
The relationship between sovereign risk and exchange rate stability has long been a subject of interest in international finance
The empirical results presented in this paper demonstrate that exchange rates and United States (US) interest rates were significant determinants of credit spreads on dollardenominated sovereign bonds of Brazil, Colombia, Mexico, the Philippines, the Russian Federation, and Turkey before the crisis, and remain so after
Using data on emerging markets, including Brazil, Colombia, Mexico, the Philippines, the Russian Federation, and Turkey, before and after the global financial crisis, the empirical results show that the exchange rates of their currencies have adequate power to explain their US dollar-denominated sovereign bond prices, in the postcrisis period
Summary
The relationship between sovereign risk and exchange rate stability has long been a subject of interest in international finance. The following section examines the empirical relationship among the exchanges rates and US dollar-denominated sovereign bond spreads of emerging markets (including Brazil, Colombia, Mexico, the Philippines, the Russian Federation, and Turkey) and the US Treasury yields. An empirical test is conducted on dollar-denominated sovereign credit spreads in emerging markets, including Brazil, Colombia, Mexico, the Philippines, the Russian Federation, and Turkey, to study their relationship with each country’s exchange rate and the yields on US Treasuries. These countries are selected because of their relatively liquid dollar-denominated bond markets. This indicates that the link between sovereign credit spreads and the dynamics of the exchange rates and US interest rates has become stronger in the postcrisis period
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