Cousin Risks: The Extent and the Causes of Positive Correlation between Country and Currency Risks

Emerging markets exhibit country risk, i.e. domestic interest rates are higher than covered interest parity’s predictions. When a country risk premium is positively correlated with the currency risk premium, a negative shock that provokes the reversal of capital flows harms the small open economy twice, causing both risk premiums to increase, thereby substantially increasing interest rates. Those periods are usually associated with low economic activity, which makes the increase in real interest rates even more detrimental since it increases the vulnerability to recessive shocks. The phenomenon of positive correlation between country and currency risk premiums observed in some countries is called cousin risks. We first identify the extent of this phenomenon by separating a sample of countries into two groups: the one where the positive correlation is observed and the one where it is not. Based on this taxonomy, we investigate the determinants of this phenomenon. The results indicate that currency mismatch and low levels of financial deepening are strongly associated with the cousin risks phenomenon.