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Nomura: Eurozone Break-Up Risk Rose

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Eurozone break-up risk has risen notably over the past few months, as European policy makers have failed to put in place a credible backstop for the larger Eurozone bond markets, according to Nomura.

Given this increased risk, investors should pay close attention to the ‘redenomination risk’ of various assets. There are important legal dimensions to this risk, including legal jurisdiction of the obligation in question. Risk premia on Eurozone assets are likely to be increasingly determined by this ‘redenomination risk’. 

In a full-blown break-up scenario, the redenomination risk may depend crucially on whether the process is multilaterally agreed and on whether a new European Currency Unit (ECU-2) is introduced to settle existing EUR contracts, said the group in a report.

Escalating tensions in the Eurozone, around Greece as well as core Eurozone countries, mean that the risk of a break-up has sharply increased. 
The potential for a break-up raises the question about the future of current Euro obligations: Which Euro obligations would remain in Euros, and which would be redenominated into new national currencies.

- Investors should consider three main parameters when evaluating „redenomination risk‟: 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.

- Redenomination risk is not only a legal matter. Redenomination risk for German assets has a different economic meaning compared with redenomination risk for Greek assets.

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