Price Cointegration between Sovereign CDS and Currency Option Markets in the Financial Crises of 2007-2013

Abstract

This working paper was written by Cho-Hoi Hui (Hong Kong Monetary Authority) and Tom Fong (Hong Kong Monetary Authority).

The sovereign credit default swap (CDS) spreads and exchange rates of the developed economies including the US, Japan, Switzerland and the eurozone with the first three countries' currencies conventionally considered as safe-haven varied in a wide range during the financial crises since late 2007. This raises the question of any interconnectivity between the anticipated sovereign credit risks of these economies and the market expectations of their exchange rates. Using a bivariate vector error-correction model with random coefficients, this paper finds evidence of cointegration and time varying conditional correlation between the prices in the sovereign CDS and currency option markets. This suggests that the relative sovereign credit risk of these developed economies impacts the market expectations of their exchange rates in the long run, but in the short run the impact changes drastically in times of crisis, resulting in drastic and persistent price deviations from their long-run equilibrium amid central banks' monetary measures and market turbulence.

Keywords: Sovereign Risk, Currency Options, Credit Default Swaps, Cointegration

JEL Classification: F31, G13