Sovereign Risk and Currency Returns

Abstract

We empirically investigate the relation between currency excess returns and sovereign risk, as measured by credit default swap (CDS) spreads. An increase in a country’s CDS spread is accompanied by a contemporaneous depreciation of its exchange rate as well as an increase of its currency volatility and crash risk. The link between currency excess returns and sovereign risk is mainly driven by exposure to global sovereign risk shocks and also emerges in a predictive setting for currency risk premia. Sovereign risk forecasts excess returns to trading exchange rates, volatility and skewness, and is strongly priced in the cross-section of currencies. Moreover, we find that sovereign risk accounts for a large share of carry trade returns, and that carry and momentum strategies generate high (low) returns across countries with high (low) sovereign risk.