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Currency Denomination Risk in the Euro Area

Summary:
In the FT (Alphaville), Marcello Minnena explains what type of currency denominations of Euro area sovereign debt constitute credit events; and how markets assess the risk of such denominations. After the Greek default in 2012 new ISDA standards entered into force: contracts made since 2014 protect against euro area countries redenominating their debt into new national currencies [unless the debt is redenominated] into a reserve currency: the US dollar, the Canadian dollar, the British pound, the Japanese yen, or the Swiss franc. In all other cases, the only way to avoid the triggering of a credit event is if the switch to the new currency does not result in a loss for the investor: “no reduction in the rate or amount of interest, principal or premium payable”. Since 2014 two types of sovereign CDS therefore coexist: the old (ISDA 2003) and the new (ISDA 2014). The latter has always traded at spreads wider than the CDS-2003, but the difference (the ISDA basis) has generally been small: 15-20 bps for Italy, 8-12 bps for Spain, 2-4 bps for France, and 1-2 bps for Germany. Since January 2017, the spread difference for Italy and France has increased by roughly 20 basis points.

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In the FT (Alphaville), Marcello Minnena explains what type of currency denominations of Euro area sovereign debt constitute credit events; and how markets assess the risk of such denominations.

After the Greek default in 2012

new ISDA standards entered into force: contracts made since 2014 protect against euro area countries redenominating their debt into new national currencies [unless the debt is redenominated] into a reserve currency: the US dollar, the Canadian dollar, the British pound, the Japanese yen, or the Swiss franc. In all other cases, the only way to avoid the triggering of a credit event is if the switch to the new currency does not result in a loss for the investor: “no reduction in the rate or amount of interest, principal or premium payable”.

Since 2014 two types of sovereign CDS therefore coexist: the old (ISDA 2003) and the new (ISDA 2014). The latter has always traded at spreads wider than the CDS-2003, but the difference (the ISDA basis) has generally been small: 15-20 bps for Italy, 8-12 bps for Spain, 2-4 bps for France, and 1-2 bps for Germany.

Since January 2017, the spread difference for Italy and France has increased by roughly 20 basis points.

Dirk Niepelt
Dirk Niepelt is Director of the Study Center Gerzensee and Professor at the University of Bern. A research fellow at the Centre for Economic Policy Research (CEPR, London), CESifo (Munich) research network member and member of the macroeconomic committee of the Verein für Socialpolitik, he served on the board of the Swiss Society of Economics and Statistics and was an invited professor at the University of Lausanne as well as a visiting professor at the Institute for International Economic Studies (IIES) at Stockholm University.

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