The role of sovereign credit risk in the FX market

<p dir="ltr">Sovereign default events are usually accompanied by a severe currency crisis and hence, increased sovereign credit risk typically prompts a flight of capital, stimulating greater fluctuations in the foreign exchange (FX) market. Further, if sovereign risk is a priced factor in currency returns, then variability in sovereign risk should generate contemporaneous FX volatility. This study investigates the contemporaneous relationship between sovereign credit risk and FX realized volatility, based on a sample of 30 currencies from January 2008 to December 2022. We examine the impact of sovereign credit risk from two different perspectives, i.e., the change and the volatility of sovereign CDS spreads. We find that FX realized volatility is positively associated with i) the change in sovereign risk and ii) the realized volatility of sovereign risk. We also split sovereign risk into a global component and a local component. Our results show that the developed countries tend to exhibit a greater impact from global sovereign risk, whereas emerging countries are more influenced by local sovereign risk.</p>