Spillovers between sovereign CDS and exchange rate markets: The role of market fear

As important variables in financial market, sovereign credit default swaps (CDS) and exchange rate have correlations and spillovers. And the volatility spillovers between the two markets become further complicated with the effect of market fear caused by extreme events such as global pandemic. This paper attempts to explore the complex interactions within the “sovereign CDS-exchange rate” system by adopting the forecast error variance decomposition method. The results show that there is a relatively close linkage between the two markets and the total spillover index of the system is dynamic. For most of the past, the exchange rate has a higher spillover effect on the sovereign CDS than vice versa. Moreover, after the market fear variables are introduced, the “sovereign CDS-exchange rate” system and market fear variables present bidirectional spillovers. The results of the study have particular significance for maintaining the financial stability and preventing risk contagion between markets.