Sovereign Risk and Out‐of‐Equilibrium Exchange Rate Dynamics

Dionísio Dias Carneiro and Thomas Wu

Review of Development Economics, 2010, vol. 14, issue 4, 699-711

Abstract: We show that the sovereign risk premium contains important information on short‐run exchange rate dynamics in emerging economies. Net foreign assets serve as the key link between both variables, which acts as a “crude form of collateral.” We present two sets of empirical evidence. First, we show that increases in net foreign assets provide a statistically significant reduction on emerging markets sovereign risk premium. Then, we show that out‐of‐sample forecasts using realized values for the sovereign risk premium have a satisfactory performance when evaluated across three metrics: the mean squared error ratio, the direction of change statistic, and the consistency criterion.

Date: 2010
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