The Impact of a Sovereign Default within the Euro Zone on the Exchange Rate

We use quanto credit default swaps to analyse the impact of a credit event in the Eurozone on the Dollar-Euro exchange rate. In light of the European debt crisis, market participants are willing to pay more for protection against a sovereign credit event if it is denominated in US Dollars rather than in Euro, because they expect the Euro to depreciate in the wake of the credit event. We use this CDS price difference to calculate the implied exchange rate conditional on a credit event, i.e., the default of a member of the Euro zone. We find that the implied effect is heterogeneous across the different countries. We identify three country groups for which the implied effect on the exchange rate develops similarly over the time horizon of our data set.