The Influence of FX Risk on Credit Spreads

We analyze the connections between the credit spreads that the same credit risk commands in different currencies. We show that the empirically observed differences in these credit spreads are mostly driven by the dependency between the default risk of the obligor and the exchange rate. In our model there are two different channels to capture this dependence: First, the diffusions driving FX and default intensities may be correlated, and second, an additional jump in the exchange rate may occur at the time of default. The differences between the default intensities under the domestic and foreign pricing measures are analyzed and closed-form prices for a variety of securities affected by default risk and FX risk are given (including CDS). In the empirical part of the paper we find that a purely diffusion-based correlation between the exchange rate and the default intensity is not able to explain the observed differences between JPY and USD CDS rates for a set of large Japanese obligors. The data implies a significant additional jump in the FX rate at default.