Exchange Rate Dynamics and United States Dollar-Denominated Sovereign Bond Prices in Emerging Markets

Abstract

The study conducts an empirical test on dollar-denominated sovereign credit spreads in emerging markets, including Brazil, Colombia, Mexico, the Philippines, the Russian Federation, and Turkey to examine their relationship with each country’s exchange rate and the United States (US) Treasury yields. The relationship between each country’s exchange rate and the pricing of each country’s US-dollar denominated sovereign bonds was particularly strong after the global financial crisis of 2008–2009. A two-factor pricing model is developed with closed-form solutions for the sovereign bonds. The correlated factors in the model are foreign exchange rates and US risk-free interest rates that follow a double square-root process relevant in a low interest rate environment. The numerical results and associated error analysis show that the model credit spreads can broadly track market credit spreads.