Sunday, November 20, 2011

Redenomination risk.

An issue as old as finance (the risk that the currency you possess from another country or culture is not what is currently used in said country) makes a comeback with respect to the Euro area.

full article here:

Investors should consider three main parameters when evaluating redenomination

1) legal jurisdiction under which a given obligation belongs; 2) whether a break-up can happen in a multilaterally agreed fashion; and 3) the type of Eurozone break-up which is being considered, including whether the Euro would cease to exist.

In a scenario of a limited Eurozone break-up, where the Euro remains in existence for core Eurozone countries, the risk of redenomination is likely to be substantially higher for local law obligations in peripheral countries than for foreign law obligations. From this perspective, local law obligations should trade at a discount to similar foreign law obligations.

In a scenario of a full-blown Eurozone break-up, evaluating the redenomination risk is more complex, as even foreign law obligations would have to be redenominated in some form. In this case, redenomination could happen either into new national currencies (in accordance with the so-called Lex Monetae principle), or into a new European Currency Unit (ECU-2). This additional complexity in the full-blown break-up scenario leaves it harder to judge the appropriate relative risk premia on
local versus foreign law instruments.

The distinction between local and foreign law jurisdiction also becomes less important in situations involving insolvency. In those instances, the lower redenomination risk associated with foreign law obligations may be negated by higher haircuts. Hence, the legal jurisdiction therefore seems most relevant from a trading perspective in connection with high quality corporate credits which are
highly resilient to insolvency.

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