Finance

What is Sovereign Risk and How to mitigate it?

Sovereign risk

Sovereign risk is basically a risk attached to the government of the country. Any risk arising out of government failing to make debt repayments or not honoring a loan agreement is a sovereign risk. For example, Countries like Argentina and Mexico had defaulted on their loan payments in the 1970s to a big extent after the oil shock. Sovereign risk impacts everyone, right from the investors, trader, other government, individuals, etc.

A country with strong economic growth, a manageable debt burden, a stable currency, effective tax collection, and favorable demographics will likely have the ability to pay back its debt. This ability will usually be reflected in a high credit rating by the major rating agencies. A country with negative economic growth, a high debt burden, a weak currency, little ability to collect taxes, and unfavorable demographics may be unable to pay back its debt.

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Sovereign credit rating

A sovereign credit rating is an independent assessment of the creditworthiness of a country or sovereign entity. Sovereign credit ratings can give investors insights into the level of risk associated with investing in the debt of a particular country, including any political risk. At the request of the country, a credit rating agency will evaluate its economic and political environment to assign it a rating. Obtaining a good sovereign credit rating is usually essential for developing countries that want access to funding in international bond markets.

How to mitigate Sovereign risk

  1. Researching Credit Ratings

There are several tools that an investor can use to protect against sovereign credit risk. The first is research. By determining if a country is able and willing to pay, an investor can estimate the expected return and compare it with the risk. Credit ratings for countries are a good place to start researching sovereign debt risk. Investors might also use third-party sources, such as the Economist Intelligence Unit or the CIA World Factbook, to get more information about some issuers.

  1. Diversification

Diversification is the other primary tool for protecting against sovereign credit risk. Owning bonds issued by several governments in different parts of the world is the way to achieve diversification within the sovereign debt market. A single negative credit event for one government will have a limited impact on a diversified portfolio. Investors can also diversify their currency depreciation risk by owning bonds denominated in several different currencies.

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Author: Akshay Patil

About the Author: When I write I learn something new which acts as a value addition towards my career in finance.

 

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