The purpose of this course is to give you a good understanding of sovereign risk and of the tools and techniques for assessing and managing sovereign risk in an investment context.
We start with a general introduction to sovereign risk. We introduce and explain basic concepts such as "restructurings", "credit events", "haircuts" and "debt relief", and we give an overview of historical sovereign debt restructuring episodes including Argentina and Greece and we discuss how they have affected investors and the broader economy. We also explain how governments have historically used "debasing" and "financial repression" as strategies for reducing real debt levels, and we discuss the possible consequences of such strategies for investors.
We then give you a thorough explanation of methods for assessing the risk that a sovereign might default on its debt obligations. We identify fundamental drivers of sovereign credit quality. We explain how to assess the "fiscal space", i.e. whether the fiscal dynamics of a particular country are on a sustainable path and how close a country is to breaking through a level of debt that will cause it to default. We explain how a country's external finance position measures how exposed a country might be to macroeconomic trade and policy shocks outside of its control. We explain the degree to which the financial sector of a country poses a threat to its creditworthiness, and we discuss factors that suggest both ability and willingness to pay off real debts. We explain and demonstrate how some of these fundamental drivers of credit quality can be used in conjunction with quantitative models such as the "Merton" model to estimate the likelihood of a sovereign default. We also explain how rating agencies use this type of information in the rating process.
Further, we look into how credit losses (and recoveries) in sovereign restructurings can be assessed. We explain different approaches to calculating the "haircuts", illustrated by historical examples. We also explain how losses can be reduced through the process of sovereign debt restructuring. We explain key elements in a debt restructuring process, the role of the "Paris Club" in restructuring bilateral debt, how bank loans are restructured under the "London Club" arrangements and how sovereign bond exchanges are negotiated and implemented. We also explain important legal aspects of sovereign debt restructurings including the so-called "collective action clauses" and possible creditor litigation actions, and we give an overview of pitfalls in the restructuring process.
Finally, we look at methods and tools for pricing, mitigating and/or transferring sovereign risk in a portfolio management context. We explain and demonstrate how credit derivatives can be used to hedge against outright sovereign defaults and against mark-to-market losses following changes in implied default probabilities (spread changes). Examples will include the use of SovX contracts to hedge a portfolio of sovereign risk. We also explain and demonstrate how diversification can be used to reduce portfolio risk and how inflation-linked products can be used to hedge against "debasement risk".