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Unformatted text preview: Chapter Sixteen Sovereign Risk Solutions for End-of-Chapter Questions and Problems: Chapter Sixteen 1. What risks are incurred when making loans to borrowers based in foreign countries? Explain. When making loans to borrowers in foreign countries, two risks need to be considered. First, the credit risk of the project needs to be examined to determine the ability of the borrower to repay the money. This analysis is based strictly on the economic viability of the project and is similar in all countries. Second, unlike domestic loans, creditors are exposed to sovereign risk. Sovereign risk is defined as the uncertainty associated with the likelihood that the host government may not make foreign exchange available to the borrowing firm to fulfil its payment obligations. Thus, even though the borrowing firm has the resources to repay, it may not be able to do so because of actions beyond its control. Thus, creditors need to account for sovereign risk in their decision process when choosing to invest abroad. 2. What is the difference between debt rescheduling and debt repudiation? Loan repudiation refers to a situation of outright default where the borrower refuses to make any further payments of interest and principal. In contrast, loan rescheduling refers to temporary postponement of payments during which time new terms and conditions are agreed upon between the borrower and lenders. In most cases, these new terms are structured to make it easier for the borrower to repay. 3. Identify and explain at least four reasons why rescheduling debt in the form of loans is easier than debt in the form of bonds. The reasons why it is easier to reschedule debt in the form of bank loans than bonds, especially in the context of post-war lending in international financial markets, include: a) Loans usually are made by a small group (syndicate) of banks as opposed to bonds that are held by individuals and institutions that are geographically dispersed. Even though bondholders usually appoint trustees to look after their interests, it has proven to be much more difficult to approve renegotiation agreements with bondholders in contrast to bank syndicates. b) The group of banks that dominate lending in international markets is limited and hence able to form a cohesive group. This enables them to act in a unified manner against potential defaults by countries. c) Many international loans, especially those made in the post-war period, contain cross- default clauses, which make the cost of default very expensive to borrowers. Defaulting on a loan would trigger default clauses on all loans with such clauses, preventing borrowers from selectively defaulting on a few loans. 1 d) In the case of post-war loans, governments were reluctant to allow banks to fail. This meant that they would also be actively involved in the rescheduling process by either directly providing subsidies to prevent repudiations or providing incentives to international agencies like the IMF and World Bank to provide other forms of grants and aid.agencies like the IMF and World Bank to provide other forms of grants and aid....
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- Spring '10