Sovereign Credit Default Swaps and the Currency Forward Bias

Abstract

We study the links between sovereign credit risk and the currency forward bias. In a setting of defaultable sovereign bonds, we show that the forward bias can be negatively linked to sovereign credit risk. We confirm empirically that the forward bias is negatively associated to sovereign CDS spreads and systematically across both developed and emerging countries but the effect is more pronounced for emerging countries. Furthermore, we show that the forward bias decreases after the inception of the sovereign CDS market. Overall, our results underscore the distinct role of the sovereign CDS market in enhancing price efficiency in currency forward and spot markets.