Explaining and Predicting Sovereign Credit Risk with Exchange Rate Volatility



Gray, Merton, and Bodie (2007) adapt Merton's (1974) structural model for corporations to make it applicable to sovereign countries that have issued both local and foreign currency debt. We apply this model to eight emerging markets. The model underestimates sovereign credit spreads, and often assigns a near-zero probability of default in contrast to CDS spreads. We do find, however, a strong time-series correlation between the model implied credit spreads and the market CDS spreads. In addition we show that the most important determinant of the distance-to-default is the exchange rate volatility. Recent changes in exchange rate volatility can predict sovereign CDS spreads.
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Sebastian Gryglewicz
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