Research Paper

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Can We Use SCDS (Sovereign Credit Default Swap) to Predict Exchange Rates?
Literature Review
CDS and Risk Premiums. The link between CDS spread changes and exchange rate changes in individual country regressions. According to Khayrattee (54), both global and regional shocks play a vital role in the link between sovereign risk and exchange rates. Regressions of bilateral exchange rates on the changes in the sovereign risk across the world result in the generation of negative slope estimates for all countries. Hence, it can be argued that sovereign CDS spreads have a much more significant impact, thereby making exposure to global factors a factor that influences exchange rates. Additionally, Shear and Butt (52) state that changes in sovereign risk of a country cause an increase in moments of the exchange rate return distribution, thus having a direct impact on the currency volatility of the country. The changes result in increasing the volatility of the country’s foreign exchange and flattening tails in the county’s foreign exchange distribution.
The UK has a substantial impact on the Greek economy, which makes changes in both the UK and the European Union, affecting Greece’s exchange rates because of the use of the Euro. For this reason, the UK is in a position to influence investors’ activities in Greece, thereby increasing Greece’s sovereign risk. This will result in forcing investors to push for higher risk premium for the time that they have been holding the country’s currency, thereby bearing associated risks. In this case, the SCDS influences activities of investors a factor that will shape the strength of Greece’s currency which ultimately affects the exchange rates of the country. As argued by Foroni, Ravazzolo, and Sadaba (259), the economic changes in the UK may result in changing the functioning of SCDS in Greece through which we can predict the country’s exchange rates. As a result, major changes in the UK economy will require the Greek government to restructure its economy, by making changes in policies on money supply and circulation. One significant change that easily affects money circulation in any given economy is an alteration in interest rates. For this reason, the use of CDS spreads can consequently be considered to be a state of macroeconomics and investor risk aversion which can be applied in predicting future economic and financial changes in Greece including exchange rates.
Coefficients for Domestic Nonbanks and Central Bank Holdings. SCDS affects emerging and advanced economies differently. According to Polat (588), the coefficients on the domestic central banks and nonbank holdings in the weaker economy are always higher than that for the stronger economy. Every percentage increase in the amount of debt held by the domestic and central banks results in a reduction in the amount of the country’s GDP. In this case, the central bank has a much more considerable impact than when domestic banks hold the debt. Besides the adverse effects that the practice has on the country’s GDP, González-Hermosillo and Johnson (64) noted that it results in increasing inflation, affecting the purchasing power of citizens as well as the ability to invest in the country. The coefficient on inflation is higher and much significant when domestic banks hold the debt than in the case of central bank holdings. Thus, the holding in the central bank of the less advanced economy is considered to be as a result of financing an inflationary budget. Studies conducted by Pallara and Renne (15) indicated that every percentage point of GDP increase in foreign bank holdings leads to an increase in the number of bond yields. The findings support the argument that the less advanced economies are much vulnerable to negative financial impacts as a result of SCDS.
The case is similar in the case of the UK and Greece. Since the UK economy is more significant and advanced than that of Greece, the Greek economy is made vulnerable when SCDS is used due to the associated harmful effects. Hence it is possible to predict changes in Greece’s interest rates using the number of holdings in the country. Since the change in the number of holdings by either the domestic or central banks affects the rate of inflation, the changes in the number of holdings can be determined by what percentage the inflation of the country will change. The change in inflation is reflected by changes in prices of goods and services, which ultimately lead to a change in the value of a country’s currency. For this reason, the Greek government will make changes in the country’s interest rate to stabilise the rate of inflation. Hence, the interest rate to be made can be predicted before it has been made by analysing the rate of change in the country’s holdings and the rate of change in inflation.
SCDS and Speculation. SDCS are used in all countries across the world. According to Munschy (37), SCDS instruments have been applied for long in speculation, leading to destabilising effects in various countries across Europe. In an attempt to curb this, European authorities introduced a ban that limited naked purchases of SDCS. As a result, the practice of holding SDCS contracts without offsetting positions was, therefore, not allowed to minimise the impact that the practice had on the countries. However, Polat (572) argues that it was later noted that investors across Europe had already incorporated the effects of the ban even before it was officially instituted. According to Pallara and Renne (115), the new regulatory setting was aimed at eliminating the remaining population that was still using the instruments to predict future changes in both the policies and destabilisation of their economies. As argued by Bostanci and Yilmaz (3), the regulatory changes had the same influence on both Greece and the UK as in all countries in the European Union. For this reason, elimination of the speculative investors leaves the market forces to operate by themselves with future outcomes being as a result of the factors of demand and supply in the country.
For this reason, the rate of interest rate in Greece relies on the changes in demand and supply of the Greek Euro. As a result, it is difficult to predict what changes will be made on Greece’s currency by the central bank since any policy to be made are to be determined by the forces of demand and supply rather than the number of holdings or SDCS in the country. The authors Bostanci and Yilmaz (3), in this case, argue that the European policies have limited the predictive use of SDCS among the states, thus making it problematic in Greece. However, the literature has not considered the impact that SDCS has on both economic and financial activities such as control of money supply. The economic changes can be used as an indicator of economic trends to take place in the country through which changes in interest rates will be predicted.
Research Question
The study will be aimed at determining whether sovereign credit default swap (SCDS) can be utilised in predicting exchange rates. To achieve this, the following research question will be used. Can we use a sovereign default credit swap to predict the foreign exchange rate between the UK’s GBP and Greece’s Euro for the period between 2016 and 2020?
Methodology
The study will apply a quantitative research design. The reason for this is to facilitate testing of the collected data, thus making the results more accurate and reliable. Additionally, the design will allow objectivity and generalisation of the results.
Data for the study will include exchange rate spreads and credit default swaps spreads on UK and Greece for the period between 2016 and 2020. The information will be gathered from Bloomberg and analysed using the Multivariate Regression Model. The reason for using the multivariate regression model is because the model allows identification of anomalies or outliers from the collected data.

Works Cited
Bostanci, Gorkem, and Kamil Yilmaz. “How Connected is the Global Sovereign Credit Risk Network?.” Journal of Banking & Finance, 2020, p. 105761.
Foroni, Claudia, Francesco Ravazzolo, and Barbara Sadaba. “Assessing the Predictive Ability of Sovereign Default Risk on Exchange Rate Returns.” Journal of International Money and Finance,vol. 81, 2018, pp. 242-264.
González-Hermosillo, Brenda, and Christian Johnson. “Transmission of Financial Stress in Europe: The Pivotal Role of Italy and Spain, but not Greece.” Journal of Economics and Business,vol. 90, 2017, pp. 49-64.
Khayrattee, Ziyaad A. London’s Lost Innovators: Understanding Brexit’s Effect On Venture Capital And Startup Investing In The UK. Diss. 2018.
Munschy, Marc. Determinants of the Expected Euro Depreciation Upon a Sovereign Default. Diss. 2016.
Pallara, Kevin, and Jean-Paul Renne. “Fiscal Limits and Sovereign Credit Spreads.” Available at: SSRN 3475425 (2019).
Polat, Onur. “Systemic Risk Contagion in FX Market: A Frequency Connectedness and Network Analysis.” Bulletin of Economic Research, vol. 71, no.4, 2019, pp. 585-598.
Shear, Falik, and Hilal Anwar Butt. “Relationship between Stock and the Sovereign CDS markets: A Panel VAR Based Analysis.” South Asian Journal of Management,vol. 11, no.1, 2017, pp. 52-67.