Sovereign Risk and Out-of-Equilibrium Exchange Rate Dynamics

We show that the sovereign risk premium contains important information on short-run exchange rate dynamics in emerging economies. Net foreign assets serve as the key link between both variables, which acts as a "crude form of collateral." We present two sets of empirical evidence. First, we show that increases in net foreign assets provide a statistically significant reduction on emerging markets sovereign risk premium. Then, we show that out-of-sample forecasts using realized values for the sovereign risk premium have a satisfactory performance when evaluated across three metrics: the mean squared error ratio, the direction of change statistic, and the consistency criterion. Copyright (C) 2010 Blackwell Publishing Ltd.