The term structure of sovereign credit default swap and the cross‐section of exchange rate predictability

• DOI: http://doi.org/10.1002/ijfe.1798
• Published date: 01 January 2021
• Date: 01 January 2021

Received: 27 February 2018 Revised: 19 April 2019 Accepted: 13 September 2019

DOI: 10.1002/ijfe.1798

RESEARCH ARTICLE

The term structure of sovereign credit default swap and the

cross-section of exchange rate predictability

Giovanni Calice1Ming Zeng2

1School of Business and Economics,

Loughborough University,Loughborough,

UK

2Department of Economics and Centre for

Finance, University of Gothenburg,

Gothenburg, Sweden

Correspondence

Giovanni Calice, School of Business and

Economics, Loughborough University,

Loughborough, LE11 3TU, UK.

Email: G.Calice@lboro.ac.uk

Abstract

Weprovide novel evidence on exchange rate predictability by using the term pre-

mia of the sovereign credit default swap (CDS). Using a sample of 29 countries,

we find that the sovereign CDS term premia significantly predict the exchange

rates out-of-sample. On average, a steeper CDS spread curve for a country

predicts its currency appreciation against the U.S. dollar (USD). Empirically,

although the sovereign CDS level mainly reflects global risk, the information

in the term premia of the sovereign CDS spreads reveals country-specific risk.

Notably, the predictive power of the term premia is robust after controlling

for the sovereign CDS level and other conventional global macroeconomic and

financial factors. Further analysis shows that the information in the sovereign

CDS term premia is also helpful for forecasting international stock market

returns.

KEYWORDS

cross-section of return predictability, exchange rate, local credit risk, sovereign creditdefault swap,

term premium

JEL CLASSIFICATION

F31; G12; G13

1INTRODUCTION

Exchange rate predictability is among the most popular

and important topics in the economics and finance litera-

ture. Since the seminal study of Meese and Rogoff (1983)

that emphasizes the inability of economic motivated vari-

ables for predicting the exchange rate, a large strand of

the literature continues searching for powerful variables

and alternative econometric methods for testing the signif-

icance of exchange rate predictability. Unfortunately, the

performance of various macro variables is in fact unsat-

isfactory, and this highlights the difficulty of identifying

robust predictors for exchange rates.

In an effort to shed light on this issue, in this paper

we argue that the information embedded in the sovereign

credit default swap (CDS) market can help us predict

exchange rates for a large cross-section of countries. The

spreads on sovereign CDS reflect a market-based assess-

ment of a country's default risk. Furthermore, the avail-

ability of CDS spreads at different maturities enables

us to measure how investors perceive sovereign credit

risk across different horizons. As the exchange rate is

essentially a forward-looking asset price, the time-varying

dynamics of a country's credit risk at various maturities

may signal meaningful movements in the exchange rate.

Therefore, we study whether the sovereign CDS term pre-

mium is helpful in predicting currency returns.

The motivation for investigating cross-market pre-

dictability is straightforward. Although traditional macro

models treat the exchange rate as the conversion between

different currencies and hence build the predictors based

on differentials in economic fundamentals, we instead

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