Sovereign Z-spread relative value and currency risk: Evidence from a cross-asset block network

This paper examines how sovereign cash-bond relative value interacts with FX option-implied risk and whether predictive connectedness changes during market dislocations. Using daily data for a panel of currencies, the empirical analysis follows a two-stage design. It first asks whether sovereign Z-spread differentials add information to an option-only system and then models Z-spreads, at-the-money implied volatility, and risk reversals jointly to compare cross-market predictive relationships between tranquil and dislocation states. The analysis controls for macroeconomic news, interest-rate repricing, and spot exchange-rate movements. The results show that adding Z-spreads leaves connectedness within FX options virtually unchanged. In the joint system, however, predictive relationships run in both directions, although their contributions to forecast variation are modest. The most consistent finding is that the option-to-bond predictive relationship changes during market stress. This state variation remains when the common U.S. bond-market component is treated differently and when stress is identified using alternative bond-market thresholds or the VIX. Its strength and direction are not uniform across these choices, however, and become less conclusive when uncertainty over stress classification is allowed for. In the opposite direction, evidence that bonds predict options weakens once the common U.S. component is separated. A further finding is pronounced currency heterogeneity: the unconditional bond-to-risk-reversal relationship is driven largely by the Japanese yen. Overall, the findings show that FX options contain state-dependent predictive information about sovereign cash-bond relative value and that cross-market relationships vary across market conditions and currencies.