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SOVEREIGN RISK CREDIT DERIVATIVES

Sovereign risk has grown with exposures to emerging markets. Country risk is somehow hybrid in nature. It can be an economic crisis, a currency crisis, apolitical crisis. A well-defined aspect of country risk is inconvertibility risk, or transfer risk. Because of the various aspects of country risk, it is important to define exactly which is the risk purchased or sold. Convertibility products address the ability of payments in another country. Such events appear as political events, but their consequences are equivalent to a credit event. A well-identified element is the non-transferability of funds outside the country, should some country event occur.

Credit derivatives hedge currency inconvertibility. The agreement provides protection for a determined period. The protection buyer pays a premium. If there is no currency inconvertibility during the agreed period, the contract terminates without benefit for the protection buyer. If there is a currency inconvertibility event, the protection buyer gets the face value of the funds in "hard" ("strong") currency. In return, the protection seller gets property of the face value in the "soft" ("weak") currency. Receiving the hard currency effectively protects the owner of the weak currency from not being able to get the money back. The protection seller should have some local usage of the inconvertible currency to make a deal. Investors in the country might have such a position.

MAIN SPECIFICS AND KEYTERMS

The main specifics of credit derivatives are, besides the nature of the contract:

• the underlying asset

• the payment terms

• the value of payment under a credit event

• the conditions defining a credit event

• the risk materialization

• legal issues with respect to risk transfers.

 
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