Exchange Rate Dynamics and US Dollar-denominated Sovereign Bond Prices in Emerging Markets

Based on an analogy between an economyi¯s currency price and a firmi¯s stock price, this paper develops a two-factor pricing model with closed-form solutions for US dollar-denominated sovereign bonds in which foreign exchange rates and US risk-free interest rates are the stochastic factors to study the dynamic linkage between the sovereign bond spreads and exchange rates in emerging markets. The numerical results during the pre-crisis (2003 - 2007) and post-crisis (2009 - 2014) periods and the associated error analysis show that the model credit spreads can broadly track the market credit spreads of the sovereign bonds of Brazil, Colombia, Mexico, the Philippines, Russia and Turkey. The results are consistent with empirical evidence of a connection between sovereign credit spreads and exchange rates, and the well-documented studies about twin sovereign debt and currency crises in emerging markets.