The term structure of sovereign credit default swaps (CDS) is indicative of country-specific financial shocks because rising country risk affects short-dated maturities more than longer-dated ones. This feature allows disentangling global and local risk factors in sovereign CDS markets. The latter align with the performance of other local asset markets. In particular, recent empirical research supports the predictive value of CDS term premia for exchange rate changes. The finding is plausible, because both local-currency assets and CDS term premia have common pricing factors, while CDS curves are cleaner representations of country financial risks.

Calice, Giovanni and Ming Zeng (2018), “The Term Structure of Sovereign CDS and the Cross-Section Exchange Rate Predictability”.

The post ties in with SRSV’s summary lecture on macro trends, particular the section of how to extract information from financial data.
The below are quotes from the paper. Emphasis and cursive text have been added.

Connections between CDS and foreign exchange markets

“If investors are consistently pricing assets across different markets, it is sensible that state variables from one asset market could predict another due to the share of risks across financial markets.”

“We develop an illustrative equilibrium model that motivates our empirical study of the sovereign CDS term premia and exchange rates…An interesting equilibrium relationship holds between the currency market and the sovereign CDS market. Indeed, we can see that there is a significant share of risk between these two markets, which reflects the consistent stochastic discount factor in pricing both assets. In fact, we can infer more information on such common risk by disentangling the two components of global and local or country-specific risks.”

The importance of the CDS term premium

“The information contained in the sovereign CDS level and its term structure has a considerably different nature. Specifically, the information embodied in sovereign CDS levels relates predominantly to global shocks, while the sovereign CDS term premium reflects mostly country-specific shocks…One may wonder why the factor structure is so different given that both quantities reflect the prospect of sovereign credit risk…Economically speaking, while the CDS level contains information on both…local and global risk…the similar loadings of CDS spreads at different maturities on global shocks tend to neutralize the global component encapsulated in the CDS term premium.”

“By successfully isolating the global impact on the sovereign CDS spreads and filtering out the local risk component, we find that in line with our hypothesis, the CDS term premium is able to effectively capture the local prospect of economic risk.…It turns out that for a wide range of variables used in the literature, the local economic states show a large explanatory power for contemporaneous changes in the sovereign CDS term structure. For…the local stock market returns denominated in local currency, the percentage changes in the local foreign reserve holdings, and the currency returns, the regression coefficients are all significant at the 1% level.”

Evidence of predictive power

“The evidence… highlights the benefits of exploiting the information role of the sovereign CDS market to construct powerful (and high-frequency) forecasting measures of exchange rates.”

“Using a sample of 29 countries, we find that the sovereign CDS term premia significantly predict the exchange rate out-of-sample. On average, a steeper CDS spread curve for a country predicts its currency appreciation against the US dollar (USD)…Notably, the predictive power of the term premia is robust after controlling for the sovereign CDS level and other conventional macroeconomic factors.”

“Overall, we find that the currency portfolios with the highest CDS term premia earn on average an annualized 4.8% higher future returns compared with those with lowest CDS term premia. The results are significant at the 5% level and are robust across different subsamples.”

“Information in the sovereign CDS term structure is also helpful for forecasting other important financial markets such as the stock markets in different countries…In line with the results on forecasting exchange rates, we find that the sovereign CDS slope emerges as the most significant predictor after we control for well-known factors documented in the international stock return literature on predictability.”