Currency Crashes and Sovereign Defaults: Two Risks But Only One Insurance Needed

Lun, 21/02/2022 - 12:00 / Lun, 21/03/2022 - 13:00

403, Viale Romania

Speaker: Ljubica Georgievska , UCLA Anderson School of Management

Abstract

To what extent are currency crashes linked to sovereign defaults? Measuring their relationship is notoriously difficult because these are rare disaster events. I take a novel approach. I learn about the risk-neutral distribution of rare currency crushes from prices of far out-of-the-money (FOM) foreign exchange options. Intuitively, these FOM options reflect the market’s assessment of currency crash tail risks. I also learn about sovereign defaults from credit default swap prices. I find a strong link between the two. The dynamic properties of this link also explain why sovereigns pay lower credit interest rates on their local currency debt versus their foreign currency otherwise equivalent debt, known as the “quanto discount spread.” However, I find puzzling evidence suggestive of segmentation between the FOM foreign exchange option and the sovereign credit markets. As a result, trading between the two markets provides generous trading profits with an annual Sharpe ratio of up to 7.2.