Exchange Rate Shocks and the Dynamics of International Asset-Backed Securities (ABS)

Abstract

This article presents a practitioner-relevant view on the response of international asset-backed securities (ABS) spreads to exchange rate shocks. We document that positive exchange rate shocks tighten international ABS spreads across maturities; the tightening is more pronounced for lower-rated ABS. Thus, the spread-reducing effects of positive exchange rate shocks are larger for lower-rated international ABS. We argue that this phenomenon relates to the potential of foreign-currency appreciation to induce risk-on sentiments in favor of the riskier foreign securities experiencing the foreign-currency appreciation, which subsequently lowers ABS spreads. For other variables, we find that the interaction between measures of risk aversion in the equities market—VIX—and in the bond market—MOVE—is important in explaining the dynamics of international ABS spreads. Specifically, a positive shock to these risk aversion measures triggers a flight to safety, which subsequently elevates international ABS spreads.

TOPICS: Asset-backed securities (ABS), emerging markets, portfolio management/multi-asset allocation, performance measurement

Key Findings

• • We examine the response of spreads to exchange rate shocks in the international ABS market.

• • A positive shock to exchange rate triggers a negative spread response (spread-tightening) that is significant across maturities and more pronounced for lower investment-rated ABS.

• • We also find that international ABS spreads relate positively with measures of risk aversion in the equities market (the VIX measure) and bond market (the MOVE measure).

• • Specifically, a positive shock to these risk aversion measures triggers a flight-to-safety response, which elevates spreads in the international ABS market.