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Borsa Istanbul Review 17-1 (2017) 1e9
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Full Length Article

Does credit default swap spread affect the value of the Turkish LIRA against
the U.S. dollar?
M. Kabir Hassan a,*, Selim Kayhan a,1, Tayfur Bayat b
a
Department of Economics and Finance, University of New Orleans, 2000 Lakeshore Drive, 70148, New Orleans, LA, United States
b
Department of Economics, Inonu University, Merkez Kampus, 44280, Malatya, Turkey
Received 4 June 2016; revised 22 July 2016; accepted 16 October 2016
Available online 26 October 2016

Abstract

We examine possible links between CDS spreads and the value of the Turkish lira against the U.S. dollar by using the recently developed
rolling window causality method as well as the Markov Switching Vector Autoregressive method. Results show that credit default swap pre-
miums drive the value of the Turkish lira against the U.S. dollar in the post crisis period. We conclude that market risk as a part of financial risk
has become an important factor in determining exchange rate fluctuations in the Turkish economy during the post-crisis period.
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Copyright © 2016, Borsa Istanbul Anonim Şirketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-
ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/).

JEL classification: F31; G10

Keywords: CDS premium; MS-VAR; Rolling window causality; Exchange rate

1. Introduction of research investigating exchange rate fluctuations (Bayat,

The driving forces of exchange rate fluctuations have been
highly debated among economists. In an early study by
Dornbusch et al. (1980) and Branson (1981), the dynamics of
exchange rates were attributed to monetary factors. In later
studies, real macroeconomic variables (Pindyck & Rotemberg,
1990; Bergstrand, 1991; Faruqee, 1995; Clarida and Gali,
1994; Mark & Choi, 1997; Chinn, 2006) as well as resource
endowments, changes in terms of trade, and productivity dif-
ferentials relative to a country's trading partners (Zalduendo,
2006) were employed to explain exchange rate fluctuations.
Commodity prices such as oil and gold were also the subject
* Corresponding author.
E-mail addresses: mhassan@uno.edu, KabirHassan63@gmail.com (M.K.
Hassan), skayhan@uno.edu (S. Kayhan), tayfur.bayat@inonu.edu.tr (T.
Bayat).
_
Peer review under responsibility of Borsa Istanbul Anonim Şirketi.
1
Permanent address: Department of Economics, Necmettin Erbakan Uni-
versity, Meram Kampus, 42060, Konya, Turkey.
Nazlioglu, & Kayhan, 2015; Golub, 1983; Krugman, 1980).
Finance theory suggests that the price of a financial asset
depends on its risk. The currency of a country is no exception
as it is akin to a financial asset (Zhang, Yau, & Fung, 2010:
440). In this regard, economists claim that “risk factor” can be
considered an important determinant of exchange rate vola-
tility. Early studies by Eichengreen and Hausmann (1999),
Eichengreen, Rose, Wyplosz, Dumas, & Weber (1995), and
Obstfeld and Rogoff (2001) sought to determine the role of
risk factor in exchange rate volatility. It is possible to explain
the effect of risk factor on a currency via the notion of sta-
bility. The strength of a currency is positively related to its
economic-political stability. Increased country risk due to
economic-political instability will lead investors to sell secu-
rities denominated in the country's currency and to repatriate
funds, hence putting downward pressure on the currency (Hui
& Chung, 2011: 2945). In this respect, an increase in country
risk would induce depreciation of the national currency. As a
result, the volatility of a currency depends highly on the level
of risk found in an economy and/or financial system.

http://dx.doi.org/10.1016/j.bir.2016.10.002
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2214-8450/Copyright © 2016, Borsa Istanbul Anonim Şirketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-ND
license (http://creativecommons.org/licenses/by-nc-nd/4.0/).
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M.K. Hassan et al. / Borsa Istanbul Review 17-1 (2017) 1e9
Thus further debate on measuring the risk of an economy
and/or financial system began among economists. Financial
risk is usually broken into three categories (Günay, 2016: 21):
market risk, credit risk, and liquidity risk. It is possible to add
political risk into these risk categories. Previous studies have
employed various indicators to measure different types of
financial risk categories, but recently a new one has enjoyed
increasing popularity because of its rising market size: credit
default swaps (CDS, hereafter). CDS is an over-the-counter
credit protection contract in which a protection seller pays
compensation to a protection buyer to make a payment in the
case of a pre-defined credit event. For credit protection buyers
who pay a fixed premium called CDS spread, the CDS market
offers the opportunity to reduce credit risk (Hui & Fong, 2015,
174). The protection seller would have the opportunity to earn
income without having to fund the position. In other words, a
CDS is a swap contract in which the contract buyer pays a
series of payments to a seller in exchange for protection from
default in the reference entity (Yang, Morley, & Hudson, 2010:
2).
The CDS market has grown over the last decade and has
thus become more prominent in finance literature (Galil,
Shapir, Amiram, & Ben-Zion, 2014: 271). The market for
CDS has ballooned from 180 billion U.S. dollars in a notional
amount in 1996 to over 54.6 trillion U.S. dollars as of the
second quarter of 2008 (Hassan, Ngow, & Yu, 2011: 2). The
growth of the CDS market makes it a useful tool to reflect the
situation in financial markets. A change in the credit risk of a
sovereign borrower reflected in its sovereign CDS spread can
thus be considered an indicator of the country's economic-
political stability, which is linked to country-specific macro-
economic variables such as output growth, foreign exchange
reserves, budget deficit, real effective exchange rate deviation,
and foreign direct investment (Hui & Fong, 2015: 174).
Moreover, the changes in credit risk premiums of sovereign
markets, which translate into changes in sovereign CDS
spreads, do not emanate from changes in the fundamentals of
the underlying economies (Hassan, Hassan, & NgowYu, 2013;
Ngene et al., 2014). Rather, these variations mirror a change in
the risk appetite of market participants in terms of credit
exposure. A negative change in the creditworthiness of a
sovereign country inevitably translates into currency depreci-
ation along with soaring currency volatility (Bekkour, Jin,
Lehnert, Rasmouki, & Wolff, 2015: 68). An increase in CDS
premium, which means that the risk of the country increases,
would lead investors to sell securities denominated in the
country's currency and to repatriate funds, hence putting
downward pressure on the currency as indicated by Hui and
Chung (2011: 2945) or vice versa.
The global finance crisis occurred in 2008, yet its effects on
the global economy are still visible. One outcome of the crisis
is that investors' risk appetite has changed. Investors increas-
ingly ask for low-risk investments even if they are low-yield.
Thus investments are more risk sensitive. Theoretically, the
response of an investor to a positive change in country risk
would not be the same as the response to a negative change.
Investors would be diffident and skeptical as risk decreases
and react slowly to the new condition. In this case, the national
currency would appreciate against any other currency only in
the longer time period. In the case of an increase in risk, in-
vestors would react rapidly and the national currency would
sharply depreciate in a very short time period.
Business cycles are another factor that impacts the risk
appetite of investors. In contraction periods, investors look for
safe havens and are more sensitive to risk. On the other hand,
investors increase their risk appetite and become more willing
to invest during expansion periods. In short, the efficiency of
the mechanism explaining the interaction between CDS spread
and exchange rate depends on business cycles. If the economy
is in a contraction period, an investor may follow a change in
CDS premiums more curiously. On the other hand, he/she may
not be so curious about it in expansion periods. In expansion
periods, when we take international capital flows into account
for an emerging economy such as Turkey, a change in CDS
premium would not affect the value of the currency via capital
inflow or outflow in a floating exchange rate regime. On the
other hand, in contraction periods, a change in CDS premium
would affect the value of the currency via capital movement
more than the case of expansionary period.
Several studies confirm the existence of a linkage between
sovereign default risk and exchange rate. The initial study
belonging to Carr and Wu (2007) investigates the Brazil and
Mexico economies and implies the causation linkage from
CDS spreads to currency option market for both of them.
Recent studies mainly focus on the Eurozone after the crisis to
understand the nature of the euro and to find the role of
increasing financial risk in the monetary union. The studies of
Hui and Chung (2011) and Bekkour et al. (2015) investigate
similar periods covering crisis times. While Bekkour et al.
(2015) find the effect of CDS premiums on the euro during
the financial crisis, Hui and Chung (2011) relate the effect of
CDS premiums to fiscal conditions of Eurozone countries.
Different from initiative studies, Omachel and Rudolf (2014)
investigate the case of the euro in the post-crisis period and
find weak causation linkages between them. Hui and Fong
(2015) examine the Eurozone, the U.S., Japan and
Switzerland, and Zhang et al. (2010) examine Japan, Eurozone
and the United Kingdom. Both studies conclude that CDS
premiums have an effect on exchange rates even if it is
contemporaneous or via expectations.
In a recent study, Della Corte, Sarno, Schmeling, and
Wagner (2015) present a broader analysis for the effect of
CDS spreads on the value of national currencies in twenty
developed and emerging economies over a long time horizon.
They find a linkage between sovereign risk and currency op-
tion as well as spot currency value in both developed and
emerging economies.
The global financial crisis, the European debt crisis,
changes in the monetary policies of developed economies, and
country/region-specific economic and political instability have
induced depreciation of the value of currencies of emerging
market economies. Like many other emerging market econo-
mies, the volatility of the Turkish lira has increased during the
recent crisis period. The Turkish lira and Brazilian real have
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M.K. Hassan et al. / Borsa Istanbul Review 17-1 (2017) 1e9
depreciated the most among fragile quintet currencies. As can
be seen in the figure below, the depreciation of the value of the
Turkish lira against the U.S. dollar is high during the period
after the global financial crisis. The nominal exchange rate
increased 102% from September 2009 to September 2015. The
high depreciation ratio of the Turkish lira compared to other
emerging currencies, in the presence of country risk, has made
the Turkish lira important to analyze (Fig. 1).
In this study, we aim to analyze the Turkish economy to
understand the interaction between financial risk and exchange
rate volatility in order to understand how changes in financial
risk affect national currency in various types of shock and
business cycle periods. To measure the risk of a financial
system, we employ CDS spreads as shown by Pan and
Singleton (2008). We use the MS VAR method in order to
see the interaction between variables in different regimes. By
doing so, we will be able to better understand the behavior of
the value of the Turkish lira against the U.S. dollar rate in
those various shock types and business cycle periods. We also
use the rolling windows causality test methods developed by
Balcılar and Ozdemir (2013) in order to see the exact dates
when the causality between exchange rate and CDS occurs.
The empirical results obtained from our analyses might be
useful in understanding whether we can use CDS premium
changes to predict exchange rate fluctuations in terms of U.S.
dollar/Turkish lira. More generally, our results may have im-
plications for the predictability of an economy's exchange rate
risk through the use of information in the sovereign CDS
market and the effects of the monetary policies adopted by
central banks on the currency and sovereign CDS markets.
Unlike existing studies, we employ recently developed cau-
sality methods and investigate the relation between CDS
premiums and exchange rates in different risk movements and
in different regimes. By doing so, we will be able to better
understand the nature of exchange rate behavior.
In the following section, we explain our econometric
methods. In the third section, we introduce the data employed
Fig. 1. Volatility in nominal exchange rate and CDS premiums. It shows volatility in CDS premium difference between Turkey and U.S. and nominal exchange rate
after the global crisis period. Time period extends from September 2009 to September 2015. Right axis shows % change in nominal exchange rate compared to
previous month. Left axis shows CDS premium difference.
3
in our model. We present the empirical results obtained from
the empirical analyses in the fourth section. Finally, we
interpret our empirical results and offer conclusions in the last
section.
2. Methodology
In this section, we introduce the empirical methods used.
First we describe the Markov Switching Vector Autoregressive
(MS VAR) method that is used to obtain impulse-response
functions for each regime to see possible differences in the
behavior of the exchange rate due to changes in the business
cycle. Secondly, we describe the rolling windows causality
analysis developed by Balcılar and Ozdemir (2013) to deter-
mine the time table of the causal relationship between
variables.
2.1. Markov Switching VAR methodology
As an empirical methodology, Markov Switching Vector
Autoregressive Model (MS-VAR) is applied to estimations of
interaction between variables in different regimes of business
cycles such as expansion, contraction, boom and recession. As
the financial sector is quite sensitive to fluctuations in the
economy, crises affect both CDS premiums and the value of
national currency against foreign currencies. Hence, MS-VAR
is a good tool for monitoring asymmetric behaviors in the
historical process and has the advantage of accommodating
structural changes across regimes, both with respect to
autoregressive dynamics and to the covariance structure of the
shocks (Binder & Gross, 2013).
In this respect, to measure the effect of a CDS premium
change on the value of national currency in different regimes,
we employ the MS-VAR method and investigate the asym-
metric behavior of interactions between variables. By
employing the method, we may better understand the relation
between CDS premium and the value of the Turkish lira
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M.K. Hassan et al. / Borsa Istanbul Review 17-1 (2017) 1e9
against the U.S. dollar and determine whether or not the
changes are due to business cycles.
In conventional models, it is not possible to know which
regime is effective at any point in time. However, in an MS-
VAR method, probabilities of all regimes for any point in
time are all known. The MS-VAR method was originally
developed by Hamilton (1989) and used by Hamilton (1989,
1990, 1994, 1996), Kim and Nelson (1998), and Krolzig
(1997, 1998, 2000, 2001) for the empirical analysis of busi-
ness cycles. Hamilton’s (1989) 2-regimes Markov Switching
Intercept Autoregressive Heteroscedasticity MSIAH-AR (p)
model takes the following form:


f1;0 þ f1;1 yt1 þ / þ f1;p ytp þ A1 εt if ðst ¼ 1Þ
yt ¼
f2;0 þ f2;1 yt1 þ / þ f2;p ytp þ A2 εt if ðst ¼ 2Þ
ð1Þ
where f1;j and f2;j denote autoregressive lag parameters for
every regime; st is the value of each regime; p shows the de-
gree of the autoregressive process; and εit is a sequence of
independent and identically distributed random variables with
mean zero [εit is iidð0; s2i Þ and s2i < ∞] (Mohd and Zahid
2006; Fallahi and Rogriguez, 2007; Kayhan, Bayat, &
Kocyigit, 2013). However, as each fundamental residual is
pre-multiplied by a switching matrix, Ai εt , the var-cov matrix
Si of the structural disturbances in Ai εt is regime-dependent as
indicated by the following transformation:
   
Si ¼ E Ai ut u0t A0i ¼ Ai E ut u0t A0i ¼ Ai I2 A0i ¼ Ai A0i ð2Þ
The main characteristic of MS-VAR is that the dynamics of
the variables are conditioned on the unobserved Markov pro-
cess followed under the regime because the Markov chain is
unobservable. After the identification of coefficients belonging
to each regime, impulse response functions are obtained by
employing the generalized impulse response function process.
2.2. Balcılar and Ozdemir (2013) bootstrap rolling
window causality test
Empirical studies that examine the causation linkage be-
tween variables may suffer from inaccurate findings from full-
sample time series data when the data series experiences
structural changes. Structural changes may create shifts in the
parameters, and the pattern of the causal relationship may
change over time (Balcılar and Ozdemir, 2013: 1400).
As mentioned before, there might be asymmetries in the
behavior of investors in addition to the business cycles. There
might be structural changes in causation linkage between CDS
premiums and the value of the national currency. In order to
deal with structural changes and parameter non-constancy, we
employ the bootstrap rolling window causality test developed
by Balcılar and Ozdemir (2013).
Balcılar and Ozdemir (2013) ran a LR (likelihood ratio)
causality test using a bootstrap method that depends on the
error term. The LR Granger causality test depending on
bootstrap has two variables VAR (p) in the model, t ¼ 1, 2,
…, T;
yt ¼ F0 þ F1 yt1 þ / þ Fp ytp þ εt ð3Þ
In the equationP above, εt ¼ ðε1 ; ε2 Þ is iidð0; s Þ is a
2
covariance matrix that is not odd. An optimal lag length
criterion is defined by Akaike Information Criteria (AIC).
While yt ¼ ½y1t ; y2t 2x1 is considered a matrix, the VAR (p)
model will be shown as
        
y1t f f ðLÞ f12 ðLÞ y1t ε
¼ 10 þ 11 þ 1t ð4Þ
y2t f20 f21 ðLÞ f22 ðLÞ y2t ε2t
P
where fij ðLÞ ¼ pk¼1 fij ; kLk , i, j ¼ 1, 2; k is the lag operator;
and Lk xt ¼ xtk . In order to avoid possible structural unit root
and to overcome any problems related to the size of the
sample, Balcılar and Ozdemir (2013) used the bootstrap test
that was modified by Koutris, Heracleous, and Spanos (2008)
and Shukur and Mantalos (2000). See the details for this
process in Balcılar and Ozdemir (2013).
3. Data description
Before describing the data and its sources, it might be
useful to show the volatility of the Turkish lira and the
movement of the CDS spread in the Turkish economy. As can
be seen in Graph 1, the value of the Turkish lira against U.S.
dollar rate is volatile during the whole period. In 2012, it is
quite stable. On the other hand, CDS spread has an increasing
trend. In the light of graphical presentation, it is possible to
imply co-movement with exchange rate volatility.
For comparison, we use the perspective of USD-based in-
vestors in our analysis. We obtain monthly data belonging to
five year sovereign CDS spreads of Turkey and the U.S. from
September 2009 to October 2015. As exchange rates reflect
the rate of exchange between the two economies' currencies,
CDS spreads are thus expressed as the differences between the
CDS spreads of the Turkish and U.S. economies (the CDS
spread of the Turkish economy minus the CDS spread of the
U.S. economy; hereafter, CDS difference). We use monthly
U.S. dollar/Turkish lira nominal exchange rate data to measure
the value of the Turkish lira.
According to Pan and Singleton (2008), CDS spreads are
related to the investors' risk appetite associated with global
event risk, financial market volatility, and macroeconomic
policy (Hui & Fong, 2015: 184). Therefore, it is important to
identify whether the sovereign CDS spreads and risk reversals
of the U.S. and Turkish economies in this study remain co-
integrated in the presence of other macro-financial factors.
In order to solve this problem, we include a set of macro-
financial variables as control variables. These are macro-
financial condition variables (S&P 500 and BIST 100 in-
dexes), interest rate difference, inflation rate difference, and
global risk appetite in the S&P stock market (VIX index).
The U.S. stock market index, proxied by the S&P 500, and
the Turkish stock market index, proxied by the BIST 100, are
used as macroeconomic control variables. To account for un-
usual turbulence in the stock market following the implosion
of the U.S. subprime market, we include the implied volatility
of the S&P 500 index option (VIX) as an additional
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M.K. Hassan et al. / Borsa Istanbul Review 17-1 (2017) 1e9 5

explanatory variable (Zhang et al., 2010: 448). Interest rate Table 1

difference data (policy interest rate of the Turkish economy ADF unit root test results.
minus the U.S. policy interest rate) is used as a control vari- Variables Level First difference
able in order to see the effects of possible increases in interest Constant Constant þ trend Constant Constant þ trend
rate differential on CDS spreads. Similarly, we include infla- BIST100 1.986 (0) 2.590 (0) 7.778 (0) 7.733 (0)
tion rate difference data (inflation rate in the Turkish economy [0.291] [0.285] [0.00]*** [0.00]***
minus inflation rate in the U.S. economy) as another macro- CDS DIF 1.471 (0) 2.156 (0) 8.211 (0) 8.283 (0)
economic control variable in the model. [0.542] [0.506] [0.00]*** [0.00]***
INF DIF 2.241 (0) 2.604 (0) 7.366 (0) 7.302 (0)
The Bloomberg database is the source of the monthly data [0.193] [0.279] [0.00]*** [0.00] ***
belonging to 5 year CDS spreads for the Turkish and U.S. INT DIF 1.757 (0) 2.296 (0) 7.252 (0) 7.266 (0)
economy, BIST 100 index, S&P 500 index, VIX index, and [0.398] [0.430] [0.00]*** [0.00]***
USD/TL nominal exchange rate. Policy interest rate and SP500 0.442 (0) 2.837 (0) 9.701 (0) 9.623 (0)
inflation rate data for both economies are obtained from the [0.893] [0.189] [0.00]*** [0.00]***
EXC RATE 2.112 (0) 0.374 (0) 6.685 (0) 7.020 (0)
International Financial Statistics database published by the [0.999] [0.986] [0.00]*** [0.00]***
International Monetary Fund. VIX 3.214 (0) 4.383 (0) 9.846 (0) 9.772 (0)
[0.023**] [0.004]*** [0.00]*** [0.00]***
4. Analysis of empirical results It shows the unit root test results. The null hypothesis claims that series contain
unit root is tested in level and first difference with a constant and constant and
One important issue to consider in MS VAR and Granger trend models separately. Results for each variable includes test statistics, lag
type causality analyses is testing the stationarity of variables. length in parentheses and probability values in brackets. If the test statistics are
lower than critical values, the null hypothesis is rejected and there is no unit
With this aim, we employ the unit root test developed by root. *, ** and *** show significance levels 10%, 5% and 1%, respectively.
Dickey and Fuller (1979, 1981) (hereafter ADF). According to
our results, BIST 100 index (hereafter, BIST100), S&P 500
index (hereafter, SP500), nominal exchange rate data (here- Table 2
Test statistics and regime determinants for VAR(2) model.
after, NEER), CDS spreads difference (hereafter, CDSDIF),
interest rate difference (hereafter, INTDIF), VIX index No. of regime Log prob LR linearity Davies AIC SC
(hereafter, VIX) and inflation rate difference (hereafter, MS(2) 14.6057 274.2465 0.00 41.6057 54.2542
INFDIF) include unit root in level, and the first differences of MS(3) 1312.2906 478.6674 0.00 46.7969 57.9191
MS(4) 997.0867 1109.0751 0.00 41.0447 55.7043
the variables are stationary. Thus the first difference of each
variable must be used in the analysis. Moreover, we include It represents the test statistics employed to determine the number of regime in
VAR (2) model. The lowest Akaike Information Criteria (AIC), Schwartz
trend and seasonality as external dummies in our model to get Information Criteria (SC) and highest LR linearity statistics denote the right
more robust results (Table 1). regime number for the model.
The first step of MS VAR analysis is to determine the
number of regimes. In Table 2, LR (rate of probability) and
Davies2 test statistics show that all regimes have a non-linear The impulse-response analysis results for the first regime
and asymmetric structure. According to the test statistics, the are presented in Fig. 3. According to our results, a 1% positive
model with two regimes has the smallest SC and AIC statis- shock in CDS difference would induce a positive shock in the
tics. It also has the biggest rate of LR. Thus, the optimal lag exchange rate and continue for three months. The response of
length is two according to the Schwarz Information Criteria. In the exchange rate is quite high and significant both statistically
light of this finding, the transition probability matrices which and theoretically. An increase in CDS difference means that
are obtained by using the MSIA(2)-VAR(2) model are pre- risk in the Turkish financial system increases relative to the
sented in Table 3. U.S. Thus, the price of the U.S. dollar will increase in terms of
According to regime transition probability results, when the Turkish lira. On the other hand, the response of the exchange
economy is in the first regime, the probability of remaining in the rate to a positive shock in the BIST is negative and statistically
same regime is 74%, while the probability of transitioning to the
second regime is 26%. On the other hand, if the economy is in
the second regime, the probability of remaining in the same Table 3
regime is 77%, while the probability of transitioning to the first Regime transition probability matrices.
regime is 23%. According to the regime analysis results, the Regime 1 Regime 2
length of regime one is 0.96 years and 1.09 years for the second Regime 1 0.7408 0.2592
regime. The speed of entrance to the second regime from the first Regime 2 0.2273 0.7727
regime is 0.32 years, while the speed of entrance to the first It represents regime transition probability matrices. The value of cell in upper
regime from the second one is 0.33 years (Fig. 2). left corner of the matrices is probability of continue to stay in the first regime
after a period in the same regime. The second cell in the first row indicates the
probability of transition to second regime from first regime. In the second row,
first cell implies the probability of transition to first regime from second
2
For detailed information about Davies asymmetry test, please see Davies regime and bottom right corner of the matrices is probability of continue to
(1977, 1987) and Garcia and Perron (1996). stay in the second regime after a period in the same regime.
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M.K. Hassan et al. / Borsa Istanbul Review 17-1 (2017) 1e9

MSIA(2)-VAR(2), 5 - 73
D BIST D CDS
DEXC D INFD
D INTD D SP 500
0 D VIX

-10000

10 20 30 40 50 60 70
Probabilities of Regime 1
1.0
filtered smoothed
predicted

0.5

10 20 30 40 50 60 70
Probabilities of Regime 2
1.0
filtered smoothed
predicted

0.5

10 20 30 40 50 60 70

Fig. 2. Smoothed avg posterior probability of regime 1 and 2. It shows the probability of regime 1 and 2 in the whole period taken into consideration. In the second
figure, blue columns show that economy is in the first regime, vice versa. Red line in figures shows smoothed probability value, while blue line shows predicted
probability.

Fig. 3. Response of EXC to 1% positive shock in other variables in regime 1. It represents the response of Turkish lira/U.S. dollar nominal exchange rate to shocks
each variable listed in data section in the first regime. The vertical axis indicates the size of response of each variable, while the horizontal axis shows the monthly
time period. Blue line symbolizes the response of nominal foreign exchange rate. If the blue line is under the horizontal axis, this means the response of nominal
exchange rate to a positive shock in any variable is negative.
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M.K. Hassan et al. / Borsa Istanbul Review 17-1 (2017) 1e9 7

significant. An increase in the BIST can be interpreted as a
capital inflow into the financial system and would appreciate
the national currency. Conversely, the response of the ex-
change rate to a positive shock in the SP500 is positive and
statistically significant. It is possible to imply that an increase
in the S&P 500 index is a capital outflow from the Turkish
financial system into the U.S. financial system. The response
of the exchange rate to a positive shock in interest rate dif-
ference, inflation rate difference, and VIX variables are
negative and statistically insignificant. This means that these
variables do not affect the exchange rate in the first regime.
The impulse-response analysis results for the second
regime are presented in Fig. 4. According to our results, the
response of the exchange rate to a positive shock in CDS
difference is positive and statistically significant for two
months. The response of the exchange rate is low relative to
the first regime. Similarly, the response of the exchange rate
to a positive shock in the BIST is negative and significant.
Conversely, the response of the exchange rate to a positive
shock in the S&P 500 index is insignificant. The impact of
interest rate difference on exchange rate is statistically sig-
nificant in the second period. An increase in the difference
between interest rates in the Turkish economy and U.S.
economy induces appreciation in the Turkish lira. This is also
significant theoretically. On the other hand, VIX variable and
inflation difference variable do not affect exchange rate
either.
According to the rolling windows causality analysis results,
causality running from CDS difference to nominal exchange
rate occurs in October 2011 and January, February, March,
April, May, June, September, and October of 2012. On the
other hand, the causation linkage from nominal exchange rate
to CDS differential occurs in December 2010; January,
February, March, and April of 2011; May, July, and October of
2013; January, February, and October of 2014; and February
and March of 2015.
When we take a look at Fig. 5, it is possible to easily see the
causality running from CDS difference to exchange rate in
2012. As is evident, the volatility of exchange rate is low and
during the same period the CDS difference between the U.S.
and Turkish economies decreases and remains stably low.
When we compare all our results with the existing litera-
ture, it is possible to conclude that our results are in line with
the literature investigating the behavior of national currencies

CDS BIST 100

0.08 1
0
0.06
1 2 3 4 5 6 7 8 9 10
-1
0.04
-2
0.02 -3
-4
0
1 2 3 4 5 6 7 8 9 10 -5
-0.02
-6
INFD INTD
0.2 0.1
0.1 0
0 -0.1 1 2 3 4 5 6 7 8 9 10
1 2 3 4 5 6 7 8 9 10 -0.2
-0.1
-0.3
-0.2
-0.4
-0.3 -0.5
-0.4 -0.6
-0.5 -0.7

SP500 VIX
0.4 0.25

0.3 0.2
0.15
0.2
0.1
0.1
0.05
0
0
1 2 3 4 5 6 7 8 9 10
-0.1 1 2 3 4 5 6 7 8 9 10
-0.05
-0.2 -0.1

Fig. 4. Response of EXC to 1% positive shock in other variables in regime 2. It represents the response of Turkish lira/U.S. dollar nominal exchange rate to shocks
each variable listed in data section in the second regime. The vertical axis indicates the size of response of each variable, while the horizontal axis shows the
monthly time period. Blue line symbolizes the response of nominal foreign exchange rate. If the blue line is under the horizontal axis, this means the response of
nominal exchange rate to a positive shock in any variable is negative.
8 _
M.K. Hassan et al. / Borsa Istanbul Review 17-1 (2017) 1e9
10% CV CDSDIF≠>NEER NEER≠CDSDIF
Fig. 5. Balcılar and Ozdemir (2013) bootstrap rolling window causality results.
It represents the timeline of existency of causation linkage between variables.
While green line represent the uni-directional causality running from foreign
nominal exchange rate to CDS diffierence, red line symbolizes uni-directional
causality running from cds difference to nominal foreign exchange rate. Blue
line represents 10% confidence interval. When red and/or green line is under
blue line, the causation linkage exists variables even in 10% significance level.
against the U.S. dollar. The findings of our study and the re-
sults of Carr and Wu (2007), Zhang et al. (2010), and Della
Corte et al. (2015) resemble one another.
5. Conclusion
This study determines the nature of causal relations be-
tween CDS spreads and the value of the national currency
against the U.S. dollar in the Turkish economy. A novel
approach to the Markov Switching VAR method, which in-
vestigates this relation in multiple periods, is applied to the
Turkish economy during the period 2009e2015. Furthermore,
we carry out the rolling window causality approach. The
method is useful for determining the exact date that causality
occurs.
The rolling window causality analysis results emphasize the
causal relationship from CDS spreads to the value of Turkish
lira against the U.S. dollar, especially in 2012 when exchange
rate volatility was relatively low and CDS spreads remained
low.
The MS VAR analysis results point out that the Turkish
economy experienced two regimes in the period between the
years 2009 and 2015. Impulse-response analysis results show
that impact of CDS spreads on the value of Turkish lira against
U.S. dollar is positive and stronger in the first period relative to
the second period. In the second period, interest rate difference
is another variable affecting exchange rate. The behavior of
investors in expanding regimes might be affected by interest
rate differentials rather than any risk factor due to changing
risk appetite; this is why we can label the second period an
expanding regime. On the other hand, the impact of risk factor
on exchange rate in the first regime might be caused by the
behavior of investors, for instance low risk appetites.
According to our results obtained from all econometric
analysis methods, there is a causation linkage running from CDS
spread to the nominal foreign exchange rate. The strength of
causality differs according to regime. These results imply that
observation of CDS spread changes might be useful to predict
exchange rate instability. This would help policymakers in sta-
bilizing the value of the Turkish lira against U.S. the dollar.
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