Euro at risk: The impact of member countries' credit risk on the stability of the currency

In this paper we focus on the Euro at risk. Specifically we investigate in detail the impact of member countries’ credit risk on the stability of the common currency. We empirically investigate the impact of the credit risk of Eurozone member countries on the stability of the Euro. In practice, in the absence of eurobonds, euro-area credit risk is induced though the credit default swaps of the member countries. The stability of the euro is examined by decomposing dollar-euro exchange rate options into the moments of the risk-neutral distribution. We argue that sovereign capital structure arbitrage ensures that new information on sovereign distress risk affects the currency. In particular, we document that during the sovereign debt crisis changes in the creditworthiness of member countries have significant impact on the stability of the euro. An increase in member countries’ credit risk results in an increase of volatility of the dollar-euro exchange rate along with soaring tail risk induced through the risk-neutral kurtosis. We find that member countries’ credit risk is a major determinant of the euro crash risk as measured by the risk-neutral skewness. We propose a new indicator for currency stability by combining the risk-neutral moments into an aggregated risk measure and show that our results are robust to this change in measure. Noticeable is the fact that during the sovereign debt crisis, the creditworthiness of countries with vulnerable fiscal positions is typically the main risk-endangering factor of the euro-stability. Interestingly, however, the market perceives Greece not to be ‘systemically relevant’.