Multi-currency (Risky) Sovereign Bonds Arbitrage

Sovereigns are active issuers both of foreign and domestic debt. The former, composed mainly of internationally traded hard currency denominated Eurobonds, serves as a direct benchmark for the creditworthiness of the country. The latter, represented by local treasuries, although considered a special asset class by global banks and funds, succeed to attract considerable investors' attention in the last decade by providing good opportunities for diversification and extra returns. In addition to the credit risk of the sovereign it reflects a whole set of extra risk factors such as inflation, exchange rate, and recovery rate. This complexity requires a proper no-arbitrage approach so that the two types of debt are priced consistently. We build such from scratch in a novel Heath-Jarrow-Morton multi-curve reduced form setting. Then we adapt it to a dynamic factors principal-component-based affine model by extending the recent advances of the framework from the riskless single-curve case. We make an empirical application to an exhaustive set of developed and emerging market countries. The results could serve as a basis for relative value analysis, creation of novel trading strategies, and construction of optimal fixed income portfolios