MONASH
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SCHOOL
BFF3651 Week 5
Risk Management:
Sovereign Risk
Unit Learning Outcomes
• On successful completion of this unit, you should be able to:
– explain the role of treasury operations in an international
or a local bank
– describe how risk management processes work
– demonstrate the application of hedging techniques used in
banks' treasury operations
– apply critical thinking, problem solving and presentation
skills to individual and/or group activities dealing with
treasury management and demonstrate in an individual
summative assessment task the acquisition of a
comprehensive understanding of the topics covered by
BFF3651.
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Resources
• Lecture note
• Saunders and Cornett’s Financial Institution
Management Chapter 14-Sovereign Risk
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Learning Objectives
• Our discussion will focus on the exposure to sovereign
risk of FIs.
– Compares sovereign risk with credit risk
– Discusses the typical forms of sovereign default
– Introduces various models of country-risk evaluation
– Introduces methods for dealing with Sovereign
default risk
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Introduction
• Opportunities of the external world matters
• Opportunities come with risk
• Trade-off: Opportunities vs. risk
• Not only foreign exchange risk but also sovereign
risk
• While you are expecting benefits from high profit
and low cost, you are being exposed to political and
economic risk of foreign countries
• Diversification: If you expand in different
economies, the net effect is averaged out.
• Is it true in the current world?
• NO>>Globalization
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Learning Objectives
• Our discussion will focus on the exposure to sovereign
risk of FIs.
– Compares sovereign risk with credit risk
– Discusses the typical forms of sovereign default
– Introduces various models of country-risk evaluation
– Introduces methods for dealing with Sovereign
default risk
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BUSINESS
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Sovereign risk Vs. Credit risk
• Sovereign risk: The risk that repayments from foreign borrowers
may be interrupted because of interference from foreign
governments.
• Sovereign default differs from credit risk per se
– Maybe independent of the borrower’s credit quality.
– Legal remedies are very limited.
• A two-step decision in terms of credit risk analysis for foreign
borrowers
– Assess the credit quality of the borrower
– Assess the sovereign risk quality of the country in which the
borrower resides
MONASH
BUSINESS
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Learning Objectives
• Our discussion will focus on the exposure to sovereign
risk of FIs.
– Compares sovereign risk with credit risk
– Discusses the typical forms of sovereign default
– Introduces various models of country-risk evaluation
– Introduces methods for dealing with Sovereign
default risk
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BUSINESS
SCHOOL
Typical forms of sovereign default
• Debt repudiation: outright cancellation of all current and future
debt obligations by a borrower
– Since WWII, only China (1949), Cuba (1961), and North Korea
(1964) have repudiated debt
– In the fall of 1996, the World Bank, the IMF, and major
governments around the world agreed to forgive the external
debt of the world’s poorest, most heavily indebted poor
countries (HIPCs), conditional on reforms targeted to improve
poverty problems, which avoids debt repudiation
– By 2021, 36 countries had received irrevocable debt relief under
the HIPC initiative, 30 of them in Africa. Together, these
countries had their outstanding debt reduced by $76 billion.
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Typical forms of sovereign default
• Debt rescheduling: changing the contractual terms of a loan, such
as its maturity and interest payments
– Most common form of sovereign risk events
– Debt moratoria: Delay in repaying interest and/or principal on
debt.
– Multiyear restructuring agreements (MYRAs) – restructure the
original debts.
– South Korea (1998), Argentina (2001), Greece (2011-12, 2015)
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Typical forms of sovereign default
• After World War II, most international debtor problems were in
the form of debt rescheduling
• Contributing factors
– Most debts are in the form of bank loans rather than bonds –
fewer lenders involved
– Often loan syndicates comprised of same group of FIs –
cohesive lenders
– Cross-default provisions – prevent selective defaults on weak
lenders
– The political pressure of the governments to bail out large FIs
(lenders in developed countries). And thus government-
organized rescue packages for LDCs were arranged via World
Bank/IMF.
– Bond defaults are likely to be more geographically and
numerically dispersed in their effects, and bond holders do not
play a key role in liquidity provision
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Debt crisis during Covid-19
• Argentina in crisis
• In case of Argentina, the cash-strapped country officially entered
into default on May 21, 2020, after failing to make a $500 million
interest payment on foreign debt. Argentina’s 2020 default is ninth
in its history, and third in this century, as Latin America’s third-
biggest economy grappled with a new cycle of economic
contraction, runaway inflation and hard-currency squeeze
exacerbated by the Covid-19 pandemic.
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BUSINESS
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Learning Objectives
• Our discussion will focus on the exposure to sovereign
risk of FIs.
– Compares sovereign risk with credit risk
– Discusses the typical forms of sovereign default
– Introduces various models of country-risk
evaluation
– Introduces methods for dealing with Sovereign
default risk
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BUSINESS
SCHOOL
Country Risk Evaluation - Outside evaluation models
• The Euromoney Country Risk Index
Real-time scores in 15 categories that
relate to economic, structural, and
political risk
• Score = 0 = maximum risk
Score=100 = no risk
• Tier 1 (80-100): Rating: AA to above
• Tier 2 (65-79.9): Rating: A- to AA
• Tier 3 (50-64.9): Rating: BB+ to A-
• Tier 4 (36-49.9): Rating: B- to BB+
• Tier 5 (0-35.9): Rating: D to B-
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Country Risk Evaluation - Outside evaluation models
• The Economist Intelligence Unit ratings
– A combined economic and political
risk rating on a 100-point scale
Score = 0 = no risk
Score=100 = maximum risk
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Country Risk Evaluation - Outside evaluation models
• Institutional Investor Index
– Based on the scores given by
the loan officers of major
multinational banks surveyed
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Country Risk Evaluation - Outside evaluation models
• OECD Country Risk
• Assess a country’s credit risk
using two basic components:
• The country risk assessment
model (CRAM)—an econometric
model that produces a quantitative
assessment of country credit risk
• The qualitative assessment that
integrates political risk and
other risk factors not fully captured
by the CRAM
• The lowest possible risk:0-1
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Country Risk Evaluation - Inside evaluation models
• Statistical Models
• Credit scoring models based on (primarily) economic ratios
• FI analyst begins by selecting a set of macro- and microeconomic
variables and ratios that might be important in explaining a
country’s probability of rescheduling.
• The selected variables are tested for predictive power in separating
rescheduling countries from non-rescheduling countries using past
data.
• Commonly used economic ratios and relation with the probability
of default (like debt-rescheduling):
• Debt service ratio
• Import ratio
• Investment ratio
• Variance of export revenue
• Domestic money supply growth
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Country Risk Evaluation - Inside evaluation models
• Debt service ratio (DSR)
– The larger the debt repayments in hard currencies are in
relation to export revenues, the greater the probability that the
country will have to reschedule its debt.
– Thus, there should be a positive relationship between the size
of the debt service ratio and the probability of rescheduling
– Example: Brazil’s total debt service ratio was 50.64 percent in
2020, suggesting that Brazil was servicing debt obligations at
half the level of its exports
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Country Risk Evaluation - Inside evaluation models
• Import Ratio (IR)
To pay for imports, the LDC must run down its stock of hard
currencies-its foreign exchange reserves.
- The greater its need for imports—especially vital imports—the
quicker a country can be expected to deplete its foreign
exchange reserves.
- The import ratio and the probability of rescheduling should be
positively related
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Country Risk Evaluation - Inside evaluation models
• Investment Ratio (INVR)
• The investment ratio measures the degree to which a country is
allocating resources to real investment in factories, machines, and
so on, rather than to consumption.
• Could be negatively related:
The higher this ratio → the more productive the economy should be
in the future and → the lower the probability that the country
would need to reschedule its debt.
• Could be Positively related:
A higher investment ratio → investment infrastructure → stronger
bargaining position with external creditors (since the LDC would
rely less on funds in the future) → less concerned about future
threats of credit rationing by FIs should it request a rescheduling.
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Country Risk Evaluation - Inside evaluation models
• Variance of Export Revenue (VAREX)
• Quantity Risk:
– the production of the raw commodities the LDC sells abroad—for
example, coffee or sugar—is subject to periodic gluts and shortages
• Price risk:
– International dollar prices at which the LDC can sell its exportable
commodities are subject to high volatility as world demand for and
supply of a commodity, such as copper, vary
– The more volatile an LDC’s export earnings, the less certain
creditors can be that at any time in the future it will be able to meet
its repayment commitments.
• a positive relationship between Variance of export revenueand the
probability of rescheduling
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Country Risk Evaluation - Inside evaluation models
• Domestic Money Supply Growth (MG)
• The faster the domestic growth rate of an LDC’s money supply →
higher the domestic inflation rate → and the weaker that country’s
currency becomes → country’s currency loses credibility as a
medium of exchange
• These inflation, output, and payment effects suggest a positive
relationship between domestic money supply growth and the
probability of rescheduling.
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Country Risk Evaluation - Inside evaluation models
• Statistical models: Summary
• Commonly used economic ratios and relation with the
probability of default (like debt-rescheduling):
– (positive) Debt service ratio: (Interest + amortization on
debt)/Exports
– (positive) Import ratio: Total imports / Total FX reserves
– (likely negative) Investment ratio: Real investment / GNP
– (positive) Variance of export revenue = σ2ER
– (positive) Domestic money supply growth = ΔM/M
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Country Risk Evaluation - Inside evaluation models
• A treasurer knows the following values and weights to assess the
credit risk and likelihood of having to reschedule a loan. From the
Z-score calculated using these weights and values, is the manager
likely to approve the loan? Validation tests of the Z-score model
indicated that scores below 0.500 were likely to be nonreschedulers,
while scores above 0.700 indicated a likelihood of rescheduling.
Scores between 0.500 and 0.700 do not predict well.
• Variable Value Weight
• DSR 1.25 0.05
• IR 1.60 0.10
• INVR 0.60 0.35
• VAREX 0.15 0.35
• MG 0.02 0.15
• Z = 0.05DSR + 0.10IR + 0.35INVR + 0.35VAREX + 0.15MG
= 0.05(1.25) + 0.10(1.60) +0.35(0.60)+ 0.35(0.15)+0.15(0.02) = 0.488
• This score classifies the borrower as a probable nonrescheduler.
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Country Risk Evaluation - Inside evaluation models
• Problems with Statistical CRA Models
• Measurements of key variables
– Lack of up-to-date information and inaccurate prediction
• Population groups
– Finer distinction beyond reschedulers and non-reschedulers may
be necessary
• Political risk factors
– Not captured in most CRA models
– Strikes, corruption, elections, revolution can drive rescheduling
– Economic Freedom Index by The Heritage Foundation.
– Corruption Perceptions Index
– [Link]
tionperceptionsindex_rep/7?e=2496456/33011041
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Country Risk Evaluation - Inside evaluation models
• Problems with Statistical CRA Models
• Political risk factors
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Country Risk Evaluation - Inside evaluation models
• Portfolio aspects
– Traditional country-by-country CRA models ignore the diversification
effect.
– Diversify the country-specific default risk by holding a portfolio of
debts across countries
– Differentiate between the systematic component and country-specific
component of factors contributing to defaults
– Example: VAR(Xi) = VAR( ) + VAR(
– Here, Xi= country risk indicator for country i
– VAR(Xi) =Total risk or variability of any given risk indicator for a
country (e.g., total risk of DSR of country i)
– =index of risk indicator of across all countries (e.g., DSR of each
country weighted by the shares of loan for each country)
– = How Xi will change for a small change in
– VAR( ) = systematic risk
– = other factors impacting Xi
– VAR( = Unsystematic risk
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Country Risk Evaluation - Inside evaluation models
• Portfolio aspects
• High-systematic risk:
– DSR
− This implies that when one LDC country was experiencing a growing
debt burden relative to its exports, so were all others.
− A possible reason for the high systematic risk of the DSR is the
sensitivity of this ratio to rising nominal and real interest rates in the
developed (or lending) countries.
– VAREX
- When commodity prices or world demand collapsed for one debtor
country’s commodity exports, the same occurred for other debtor
countries as well.
•Low-systematic risk:
- Money supply Growth and Import Ratio
- This is not surprising since control over the money supply and the
use of domestic reserves are relatively discretionary variables for
LDC governments
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Country Risk Evaluation - Inside evaluation models
• The average (or VAREX = variance of export revenue) of a
group of countries has been estimated at 20 percent. The
individual VAREXes of two countries in the group, the Netherlands
and Singapore, have been estimated at 15 percent and 28 percent,
respectively. The regression of individual country VAREX on
average VAREX provides the following beta (coefficient) estimates:
• N = Beta of the Netherlands = 0.80
• S = Beta of Singapore = 0.20.
• Based only on the VAREX estimates, which country should be
charged a higher risk premium? Singapore
• If FIs include systematic risk in their estimation of risk premiums,
how would your conclusions to part (a) be affected? Netherland
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Country Risk Evaluation - Inside evaluation models
• Problems with Statistical CRA Models
• Incentive aspects
– Most CRA models lack a sophisticated analysis of the benefits versus
costs of defaults for both borrowers and lenders.
Borrowers:
• Benefits:
– By rescheduling its debt, the borrower lowers the present value of its
future payments in hard currencies to outside lenders.
• Costs:
– borrower may close itself out of the market for loans in the future.
– Rescheduling may result in significant interference with the
borrower’s international trade
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Country Risk Evaluation - Inside evaluation models
• Problems with Statistical CRA Models
• Incentive aspects
Lenders:
• Benefits:
– Once a loan has been made, a rescheduling is much better than a
borrower default.
– The FI can renegotiate fees and various other collateral and option
features into a rescheduled loan
– There may be tax benefits to an FI’s taking a recognized write-down or
loss in value on a rescheduled LDC loan portfolio
• Costs:
– Through rescheduling, loans become similar to long-term bonds or
even equity, and the FI often becomes locked into a particular loan
portfolio structure
– Those FIs with large amounts of rescheduled loans are subject to
greater regulatory attention
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Country Risk Evaluation - Inside evaluation models
• Problems with Statistical CRA Models
• Stability
– The fact that certain key variables may have explained rescheduling in
the past does not mean that they will perform or predict well in the
future.
– New variables and incentives affect rescheduling decisions, and the
relative weights on the key variables change.
– Treasurers must continuously update the CRA model to incorporate
all currently available information and ensure the best predictive
power possible.
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Using Market Data to Measure Risk
• Quoted prices provide information about investors’ perception
about default risk in these debts.
• Buyers: Wealthy investors, hedge funds, FIs seeking to engage in
debt-for-equity swaps or speculative investments; FIs seeking to
rebalance their foreign debt portfolios.
• Sellers:
– Large FIs willing to accept write-downs of loans on their
balance sheets
– Small FIs wishing to disengage themselves from the LDC loan
market
– FIs willing to swap one country’s debt for another’s to
rearrange their portfolios of country risk exposures
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Using Market Data to Measure Risk
• Market segments:
• Sovereign bonds: Uncollatirized bonds issued by
Governments
– Bonds price or value reflects the credit risk rating of
the country issuing the bonds
• Performing LDC loans: original or restructured
outstanding sovereign loans on which the sovereign
country is currently maintaining promised payments to
lenders or debt holders.
• Nonperforming LDC loans: There are no interest or
principal payments currently being made in this loan.
– These are normally traded at very deep discounts
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Learning Objectives
• Our discussion will focus on the exposure to sovereign
risk of FIs.
– Compares sovereign risk with credit risk
– Discusses the typical forms of sovereign default
– Introduces various models of country-risk evaluation
– Introduces methods for dealing with Sovereign
default risk
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BUSINESS
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Dealing with Sovereign default risk
• Loan sales
– Major benefit is the removal of these loans from the balance sheet
– Signals that FI’s balance sheet is sufficiently strong to bear the cost
since loans are sold at discounted prices. This can have positive impact
on lenders’ stock price.
– FI shares part of the loan sale loss with the government because such
losses provide a tax write-off for the lender
• Bond-for-loans swaps
– Transform LDC loan into marketable liquid instrument
– Low transaction costs, small bid–ask spreads, and an efficient clearing
and settlement system.
– Have full or partial collateral backing
– Usually senior to remaining loans of that country
– Problem: Bonds maturity could be longer than loan maturity
– Example: Brady bonds
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Dealing with Sovereign default risk
• Debt-for-equity swaps-Example:
• Citibank sells $100 million Chilean loan to Bank of America for $91
million
• Bank of America (market maker) sells to IBM at $93 million
• Chilean government allows IBM to convert the $100 million face value
loan into pesos at a discounted rate to finance investments in Chile
• Example: If the free market exchange rate was 380 Chilean pesos to the
U.S. dollar, the Chilean government will convert the dollars only at 361
pesos to the U.S. dollar. Thus, IBM must bear a 5 percent discount on the
face value of the purchased loan; that is, when converting the $100 million
loan at the Chilean Central Bank, IBM receives $95 million equivalent in
pesos.
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Dealing with Sovereign default risk
• Multiyear restructuring agreements (MYRAs) – restructure the original
debts. Benefits and costs depend on:
– Fee charged by FIs for restructuring
– Interest rate charged on the new loan
– Grace period for payments on new loan
– Maturity of new loan – normally lengthened
– Option and guarantee features
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Conclusion
• Our discussion will focus on the exposure to sovereign
risk of FIs.
– Compares sovereign risk with credit risk
– Discusses the typical forms of sovereign default
– Introduces various models of country-risk evaluation
– Introduces methods for dealing with Sovereign
default risk
MONASH
BUSINESS
SCHOOL