Abstract
This study examines the impact of sovereign risk on exchange rate volatility in 36 developed and emerging countries from 2009 to 2025. This research suggests that sovereign credit risk, indicated by Credit Default Swap (CDS) spreads, spreads across borders through financial connections, which in turn has a major impact on currency volatility. To test this, exchange rate volatility is decomposed into short-run and long-run components using a Component GARCH model. The Spatial Durbin Model (SDM) is employed in the study to capture the interdependencies between countries. The results show strong evidence of significant spatial dependence. When a country's sovereign risk increases, its own short-run exchange rate volatility rises, as do those of nearby countries, indicating considerable spillover effects. These spillover effects are very nonlinear, increasing sharply during times of high volatility and market stress, which strongly suggests that crisis-driven contagion exists. On the other hand, sovereign risk does not significantly affect long-run exchange rate volatility, indicating that its effects are temporary rather than structural. The findings suggest that sovereign risk is a powerful factor in short-term currency instability and cross-border financial contagion. To ensure robust causal inference and address potential endogeneity, an Instrumental Variable Quantile Spatial Durbin Model (IV-QSDM) is applied, confirming that the results remain consistent even after controlling for reverse causality. This highlights the need for proactive policies, such as enforcing fiscal discipline and strengthening regional financial safety nets to reduce the impact of sovereign risk shocks, especially during crises.