Sovereign risk is defined as potential defaulting by the government’s treasury on their sovereign debt. The recent global financial crisis and European crisis created complex spillover effects in various sectors. The spillovers highlighted the need for sovereign and banking-sector (industry) risks to improve interactions and feedback mechanisms (Gray & Malone, 2012). In this regard, this paper proposes a contingent claim analysis (CCA) as a reliable conceptual framework to analyses sovereign and industry risks or their interlinkages. The framework incorporates the balance sheet data as well as high-frequency market data towards capturing critical risks transmission and measuring risk exposure or feedback channels amidst sovereign risks.

Swot Analysis

Sovereign risks are usually low. During financial crisis however, sovereign risks tend to create losses for banking institutions experiencing the crisis and bond investors, in what is commonly defined as sovereign debt crisis. In addition, sovereign risks teds to affect forex traders who hold contract with leverage for the nation’s currency (Gray & Malone, 2012). While sovereign risks manifests in various forms such as liquidity risk, interest risk, exchange risks and price risks, any person experiencing the sovereign risks is always exposed to the crisis affecting the foreign country. Investors and foreign exchange traders are usually exposed to the risk that the central bank of the foreign country may revise it monetary policy in a manner that affects currency trades. In such cases the central bank would change the currency policy from a pegged currency to a float currency thereby altering the benefits of currency investors.

The proposed contingency claim analysis targets aspects such as the ability to pay and the willingness to pay. A government’s ability to pay can be understood form its current economic position. In most cases, countries with manageable debt burden, effective tax collection, a growing economy, a stable currency and favorable demographics have higher ability to settle their debts. Such factors are usually indicted through a high rating by major rating institutions such as Forbes. On the other hand, countries with poor economic growth weak currency, high debt burden, unfavorable demographics and poor tax collection methods are understood to be most unlikely to pay their debts. The aspect of willingness to pay, surrounds the feedback mechanisms especially in relation to government leadership or the political system. There have been cases where government would oblige to pay despite being in the position to pay their debts. Nonpayment has particularly been the case of nations that change governments as a result of political instability. The CCA thus considers the need to conduct a political analysis when investing on sovereign bonds.

Recommendations

Bach air, (2016) observes that government on-lending and sovereign credit guarantee facilitates the fulfillment of certain policy objectives as well as boosting the private sector investment. Sovereign risks thus remain integral for bond investors such as banking institutions. Contingent liabilities target the contingent assets being on on-lending risk exposure of governments’ proposed CCA should include the following four steps to measure the credit risks.

1. Establishing aspects that define the risk analysis approach
2. Risk drivers’ analysis
3. Quantifying the risks
4. Application and quantification of the risk analyses