Assessing the Predictive Ability of Sovereign Default Risk on Exchange Rate Returns

Claudia Foroni, Francesco Ravazzolo and Barbara Sadaba

Staff Working Papers from Bank of Canada

Abstract: Increased sovereign credit risk is often associated with sharp currency movements. Therefore, expectations of the probability of a sovereign default event can convey important information regarding future movements of exchange rates. In this paper, we investigate the possible pass-through of risk in the sovereign debt markets to currency markets by proposing a new risk premium factor for predicting exchange rate returns based on sovereign default risk. We compute it from the term structure at different maturities of sovereign credit default swaps and conduct an out-of-sample forecasting exercise to test whether we can improve upon the benchmark random walk model. Our results show that the inclusion of the default risk factor improves the forecasting accuracy upon the random walk model at short forecasting horizons.

Keywords: Econometric and statistical methods; Exchange rates; International financial markets (search for similar items in EconPapers)
JEL-codes: C22 C52 C53 F31 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2017
New Economics Papers: this item is included in nep-cba and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Journal Article: Assessing the predictive ability of sovereign default risk on exchange rate returns (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:17-19

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