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

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.