Wednesday, October 17, 2012

Expected exchange rates in the case of a sovereign default (os)

What happens to the Euro-Dollar exchange rate if a euro zone member succumbs to a sovereign default?
Obviously the answer depends. The intensity, as well as maybe the direction, are susceptible to the country we are talking about. My colleague Arne Breuer and myself have written a short working paper on that issue. Have a look at the abstract:
We use quanto credit default swaps to analyse the impact of a credit event in the Euro zone on the Euro-Dollar exchange rate. In light of the European debt crisis, market participants are willing to pay more for protection against a sovereign credit event if the payment in such an event is denominated in US-Dollar rather than in Euro, because they expect the Euro to depreciate in the wake of the credit event. We use this CDS price difference to calculate the implied change of the exchange rate conditional on a credit event of a member of the Euro zone. We find that the implied effect is quite heterogeneous across the different countries. In addition, we identify three country groups for which the implied effect on the exchange rate developed similarly over the time horizon of our data set.

You can download the paper at ssrn, All comments are welcome!