Exchange Rates and Sovereign Risk: a Nonlinear Approach Based on Local Gaussian Correlations

Reinhold Heinlein (), Gabriella Legrenzi and Scott Mahadeo ()
Additional contact information
Reinhold Heinlein: Bristol Business School, University of the West of England
Scott Mahadeo: Department of Economics, University of Reading

No em-dp2025-03, Economics Discussion Papers from Department of Economics, University of Reading

Abstract: We empirically assess the interlinkages between sovereign risk, measured in terms of CDS spreads, and exchange rates for a sample of emerging markets. Our period of analysis includes episodes of severe stress, such as the Global Financial Crisis, the COVID-19 pandemic, and the Ukrainian War. Exploiting recent developments in local Gaussian partial correlation analysis and the associated nonlinear Granger causality tests, we are able to uncover linkages between assets across different segments of their joint distributions. Disentangling the effect of global factors, we show that the information on sovereign risk of other emerging economies is more relevant for the sovereign risk-exchange rate relationship than the state of developed markets risk for all countries in our sample and for all segments of the assets distribution. The same considerations apply for the movements of the US dollar relative to other currencies, where changes in emerging market currencies is of particular interest. Nonlinear Granger causality tests show bi- directional causality for most countries, confirming the importance of multiple transmission channels. Taken together, our results highlight the importance of understanding the interlinkages between sovereign risk and exchange rates across their entire joint asset returns distribution, which can guide policymakers in debt and currency management, with coordinated regional responses potentially proving more effective than individual national actions. In terms of portfolio management, our documented bidirectional causality offers valuable insights into predicting currency fluctuations based on sovereign risk, supporting hedging and investment strategies in periods of financial stress.

Keywords: CDS; correlation; emerging markets; exchange rate; nonlinear causality; sovereign risk (search for similar items in EconPapers)
JEL-codes: F31 G15 (search for similar items in EconPapers)
Pages: 26 pages
Date: 2025-11-01
New Economics Papers: this item is included in nep-cis
References: Add references at CitEc
Citations:

Downloads: (external link)
https://research.reading.ac.uk/economics/wp-conten ... 25/11/emdp202503.pdf

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:rdg:emxxdp:em-dp2025-03

Access Statistics for this paper

More papers in Economics Discussion Papers from Department of Economics, University of Reading Contact information at EDIRC.
Bibliographic data for series maintained by Alexander Mihailov ().