Theory and evidence on the dynamic interactions between sovereign credit default swaps and currency options

Peter Carr, Liuren Wu

Research output: Contribution to journalArticle

Abstract

Using sovereign CDS spreads and currency option data for Mexico and Brazil, we document that CDS spreads covary with both the currency option implied volatility and the slope of the implied volatility curve in moneyness. We propose a joint valuation framework, in which currency return variance and sovereign default intensity follow a bivariate diffusion with contemporaneous correlation. Estimation shows that default intensity is much more persistent than currency return variance. The market price estimates on the two risk factors also explain the well-documented evidence that historical average default probabilities are lower than those implied from credit spreads.

Original languageEnglish (US)
Pages (from-to)2383-2403
Number of pages21
JournalJournal of Banking and Finance
Volume31
Issue number8
DOIs
StatePublished - Aug 2007

Keywords

  • Currency options
  • Default arrival rate
  • Option pricing
  • Return variance dynamics
  • Sovereign credit default swaps
  • Term structure of credit spread
  • Time-changed Lévy processes

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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