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Cambridge Centre for Risk Studies

Cambridge Risk Framework
Sovereign Default Crisis Stress Test Scenario


Cambridge Centre for Risk Studies
University of Cambridge Judge Business School
Trumpington Street
Cambridge, CB2 1AG
United Kingdom

December 2015

The Cambridge Centre for Risk Studies acknowledges the generous support provided for this
research by the following organisations:

The views contained in this report are entirely those of the research team of the Cambridge Centre for Risk Studies, and
do not imply any endorsement of these views by the organisations supporting the research.

This report describes a hypothetical scenario developed as a stress test for risk management purposes. It does not
constitute a prediction. The Cambridge Centre for Risk Studies develops hypothetical scenarios for use in improving
business resilience to shocks. These are contingency scenarios used for ‘what-if’ studies and do not constitute forecasts
of what is likely to happen.

Sovereign Default Crisis Stress Test Scenario

Eurozone Meltdown

1  Executive Summary 2
2  Financial Catastrophe Stress Test Scenarios 6
3  Sovereign Default as a Financial Catastrophe 10
4  Defining the Scenario 12
5  The Scenario 14
6  Macroeconomic Analysis 15
7  Impact on Investment Portfolio 23
8  Mitigation and Conclusions 30
9 Bibliography 31

Cambridge Centre for Risk Studies Sovereign Default Crisis Stress Test Scenario Eurozone Meltdown 1  Executive Summary Sovereign default is a failure or refusal by a country’s The overall expected output loss.1 in the Cambridge Taxonomy of Threats. we explore how this might cascade While the “standard” scenario variant S1 limits such further to trigger the creation of shadow currencies a contagion on the peripheral countries. number of countries and affects other economies that are typically thought of as being core countries of the Variants of the scenario Eurozone. expressed as lost government to make a repayment of national debts.2. These scenarios cause a worldwide recession lasting just over a year (approximately five to six fiscal quarters). and popular unrest at austerity measures put in place to repay debt fully. “Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten”.3 and $23. reduction in tax scenarios is a basis for a global enterprise to stress receipts. although the pure weaker European economies – Italy and the other so- financial market risks now seem to be under control called PIGS (Portugal. Such devaluations can have a similar financial effect as A History of Country Defaults defaults which. to a X1 this further leads to the meltdown of the Eurozone Eurozone meltdown with severe global effects. In this scenario political pressures force a bloc of European countries into a cascade of exits from The Eurozone Meltdown Scenario describes scenarios the currency union. is between $11. test itself and improve its resilience. some of the still endanger the currency union. In the most extreme variant the more severe scenario variants. 1    C. The Great Recession of 2007-2011. from Scenario selection one of our four Financial Catastrophe scenarios. sequential exit of countries from a currency union.. December 2013 2 . high debt in a currency that creates dimension of the scenario. K. global Gross Domestic Product during the scenario Consequences include devaluation of the principal. Reinhart.2 trillion. devaluation of fixed income assets resulting from a comparatively. political costs that cannot be managed by the affected sovereign. decline in employment levels. government regulation or perceived threats of Eurozone Meltdown regulation of financial markets. in in Germany and France. with 120 of them spectrum of extreme shocks. i.e. low risk investments. These problematic political drivers might In our “standard” scenario variant S1. Ireland. A suite of public debt in foreign currencies. compared with the projected rate of growth without as well as loss of yield from the bond. corruption. A premise is that increasing connectedness The exit from the Euro spreads by contagion of of global financial markets widens channels for the similar political and economic issues across a contagion. the catastrophe occurring (“GDP@Risk”). if occurring in what are conventionally regarded as high quality. Rogoff. In variant S2. which Causes of defaults include major increases in encompasses five classes of business risk. saw a loss of $20 trillion in 2015 cascade of sovereign debt devaluations caused by the dollar estimates. Greece and Spain) – as a powerful rescue architecture has been set up are caught up in a wave of negotiated currency exits. since 2011. $16. such as those proposed occurring in the past century. Over the past two hundred years there have been over Scenarios more generally can be used to cover the 180 recorded sovereign defaults. S2 and X1. in the sense of a complete dissolution of the Euro. IMF Working Paper 13/266. The speed and rapid incidence comparable to a default driven by the first of these of multiple countries exiting is the most significant causes. it comes. depending on the This report explores the impact of unexpected variant narrative.

measures that constitute the monetary and fiscal For portfolio protection it is recommended that framework of the currency union and hence triggering equity allocation is shifted away from Europe towards an exit from the Eurozone. It represents just one example of such Economics’ Global Economic Model (GEM). The cascade of Eurozone defaults has a significant impact on the world economy. We default all corporate bonds conservatively given Cascade of exits from the Eurozone the 2008 default rates and government bonds using the most severe government defaults in history. currencies in both countries. It does not predict a cash flows while keep the allocation percentages fixed. Risk management strategies Political reactions in the core countries Scenarios as stress tests The costly exits of the peripheral countries have finally put populist. It is a “what- currency depreciation is calibrated between 25 and if” exercise. designed to provide a stress test for risk 40%. operational risk management plans around Hence. and counterparty challenges. catastrophe. and these populist parties performing equity is the German equity index (DAX) manage to channel public dissatisfaction.5 to 15 percentage points. The High Inflation World scenario is just one example of These parties support the evolvement of shadow a wide range of scenarios that could occur. This yields “GDP@Risk” wishing to assess how their systems would fare under which estimates the loss to the global gross domestic extreme circumstances. Populist government in Italy The economic shocks are applied generally over 5 Against the backdrop of Germany’s continued hard years and we see the portfolio not recover over the line on servicing Italy’s debt stroked a rebellion among baseline performance. A weak Euro without political support is an This scenario aims to improve organizations’ economical risk for the remaining member countries. The worst protesting anti-austerity. worst performing portfolio structure is the aggressive Coming into power. The a catastrophe and is not a prediction. it is negotiated to completely dissolve this contingencies. peripheral countries to follow suit. not a prediction Financial market impact This report is one of a series of stress test scenarios We estimate the portfolio impacts of this scenario by that have been developed by the Centre for Risk modelling the outputs from Oxford Economics’ GEM Studies to explore management processes for into portfolio returns.2 trillion across the variants. these parties reject the stability with a -13.e. Eurozone Meltdown Scenario. 3 . anti-Euro parties into power This scenario is an illustration of the risks posed by even in Germany and France. together and the best performing stocks is Japan (N225). The and monetary union. The third-party movement draws experienced for the Conservative portfolio in the S1 widespread support from the disgruntled Italians variant is -9. the cumulative effect of this scenario on the global economy. and short-term interest rates are driven up by management purposes by institutions and investors 0. GDP@Risk is between $11. and strategies for surviving financial currency. product over 5 years.2 and $23. Spill over effects from the Japan and away from Euro fixed income towards US political and economic agenda from Italy force other fixed income.41% loss for the S1 variant. we apply shocks to This scenario is an illustration of the risks posed exchange rates and short-term central bank interest by a plausible but extreme financial market based rates in defaulting countries within the Oxford catastrophe. indicating a more severe effect than the Great Financial Crisis if the Eurozone in its entirety were to fail and disband. further weakening the Euro.86% nominal occurs in Yr1Q2. The maximum downturn the Populist parties. projecting market changes and dealing with an extreme shock.. It presents a capital stress test for insurers to assess their ability to Global GDP Impact manage underwriting losses while also suffering To estimate the macroeconomic impact of the market impacts on their investment portfolios. social unrest triggered by catastrophic event. with the economic difficulties caused by a series of The worst performing fixed income bonds are the long-overdue reforms against the European political German while the US bonds perform the best. Eurozone Meltdown Stress Test Scenario This is a stress test. i.

Cambridge Centre for Risk Studies Summary of Effects of Eurozone Meltdown Scenario and Variants Scenario Variant S1 S2 X1 Variant Description Standard Scenario Scenario Variant Extreme Variant Greece. S1 plus France and Defaulting Countries S2 plus the Eurozone Portugal and Ireland Germany World food price shock 180% 250% 310% Currency Exchange Rates Shock 25 – 40% 25 – 40% 25 – 40% Gross Government Debt Shock 50% 50% 50% Macroeconomic losses Global recession severity 0% -1.9% (as % of 5-year baseline GDP) Portfolio Impact Performance at period of max downturn High Fixed Income -5% -16% -18% Conservative -10% -25% -28% Balanced -12% -29% -31% Aggressive -13% -32% -35% Asset class performance Yr1Qr4 Yr3Qr4 Yr1Qr4 Yr3Qr4 Yr1Qr4 Yr3Qr4 US Equities (W5000).3 Trillion $23.2 Trillion (5 year loss of global output) GDP@Risk % 2.8% -2. % Change -18% -36% -61% -76% -64% -82% German Treasuries 10yr Notes. % Change -4% -2% -10% -15% -15% -39% UK Equities (FTSE100). % Change -13% -18% -68% -65% -70% -69% Table 1:  Summary impacts of the Eurozone Meltdown scenario 4 .1% 5.6% (Minimum qtrly growth rate global GDP) Global recession duration N/A 5 Qtrs 6 Qtrs GDP@Risk $Tr $11.2 Trillion $16. Italy. % Change -21% -2% -36% -15% -43% -39% German Treasuries 2yr Notes.8% 4. Spain.

Eurozone Meltdown Stress Test Scenario Trillion US$ GDP@Risk across scenarios S1 S2 X1 Millennial Uprising Social Unrest Risk 1.6 -1.6 China-Japan Conflict Geopolitical War Risk 17 27 32 2007-12 Great Financial Crisis 18 Great Financial Crisis at 2014 20 Table 2:  GDP@Risk impact of the Eurozone Meltdown scenario compared with previous Centre for Risk Studies stress test scenarios 5 .9 8 10.9 1.5 7.6 De-Americanization of the Financial System Risk Sybil Logic Bomb Cyber Catastrophe Risk 4.3 23.2 Global Property Crash Asset Bubble Collapse Risk 13.9 Sao Paolo Influenza Virus Pandemic Risk 7 10 23 Eurozone Meltdown Sovereign Default Risk 11.4 15 High Inflation World Food and Oil Price Spiral Risk 4.6 4.1 Dollar Deposed 1.6 8.2 19.2 16.

Understanding financial catastrophe threats • supply chain risk and the ability of an institution to effectively manage its input requirements This scenario explores the consequences of a financial through its supply chain. In 2008. wishing to assess how their systems would fare under extreme circumstances. governments. This exercise would ideally stress and how this may impact on the business. interconnected. and this work package and includes the following: households can ultimately lead to systemic instability. As global financial systems become increasingly • Global Property Crash: Asset Bubble Collapse. the stress tests allow institutions to aggregate shocks and (iii) contagion (Sarlin. (ii) macro stress-testing. include a thorough analysis for each different type of • reputational risk and the protection of brand market catastrophe in addition to the four financial image for reacting appropriately and confidently catastrophes included in this suite of stress tests. It represents just one example of such they are intended to be explored as a suite in order a catastrophe and is not a prediction. sectors and businesses throughout the are an essential tool for identifying and assessing networked structure of the economy. Market catastrophe risk and financial contagion This scenario is one of a series of stress test scenarios The Great Financial Crisis of 2007-8 not only developed by the Centre for Risk Studies to explore revealed the extent to which the global financial the management processes for dealing with an system is interconnected but how interrelationships extreme shock event. help deal with decision support: (i) early-warning systems. 100 possibility for a High Inflation World Scenario and examining how the shock would work through • customer demand risk and knowledge for how the system.Cambridge Centre for Risk Studies 2  Financial Catastrophe Stress Test Scenarios This scenario is an illustration of the risks posed Each individual scenario may reveal some aspects by a plausible but extreme financial market based of potential vulnerability for an organisation. under crisis conditions. New models of the global financial system impact regions. These financial potential risks and vulnerabilities that may lead to a stress tests aim to improve organisations’ operational systemic financial crisis. It is one of four financial between commercial banks. and (iii) contagion These risks include: models. investment banks. we need to consider how • market or segmentation risk and an understanding different market-based catastrophes occur and then of how other firms within the same sector will propagate these shocks through global financial react and perform during periods of financial and economic systems. a shock to one part of the system has • Dollar Deposed: De-Americanisation of the the potential to send a cascade of defaults throughout Global Financial System. manage and build resilience to different forms of risk Similarly we work with three analytical methods that during periods of financial stress. 2013). to meet internal market catastrophe by examining the notional 1-in- production and operational requirements. It is a “what. (i) build-up of wide-spread imbalances. demand might shift for goods and services during periods of low investment and consumer spending. it was only through government intervention in the form of extensive bailout packages that a The scenarios present a framework for understanding widespread collapse of the global financial system was how global economic and financial collapse will avoided. risk management plans to form contingencies and strategies for surviving and minimising the The literature identifies three types of systemic risk: impacts from market-based financial catastrophe. • High Inflation World: Food and Oil Price Spiral. For a process that truly assesses resilience to market catastrophe. designed to provide a stress test for risk unexpected shocks that are complex and have multi- management purposes by institutions and investors faceted impacts. corporations. to identify ways of improving overall resilience to if” exercise. market catastrophe scenarios being modelled under central banks. but catastrophe. the entire network. All three methods are actively under research • financial and investment risk stemming from a in the Centre for Risk Studies and utilised in the collapse in asset prices across different sectors development of these stress test scenarios. (ii) exogenous In particular. and regions. 6 .

macro-catastrophe threats with the potential to cause damage and disruption to a modern globalised world. using standardized hypotheses. a cause of disruption. This can be seen in Figure 1 and includes a list of seven unique financial. 1825 Latin American Banking Crisis. but not probable. market and economic catastrophes. We have also estimated how the event would researching scientific conjecture and counterfactual impact investment asset values. extreme event that is driven by a number To develop a coherent stress test we have devised a of factors and would cause significant disruption to methodology for understanding the consequences of normal lifestyles and business activities. collating other using the OEM to calculate losses in expected GDP disaster catalogues and categorization structures. The recent Great Financial Crisis (GFC) is one example of this. as summarised in Figure 2. investment portfolios to show the effect on indicative The resulting Cambridge taxonomy catalogues those aggregate returns. Each scenario is selected as a plausible.e. combined with a final review process. Eurozone Meltdown Stress Test Scenario Such an analysis would also include a range of They are illustrative of the type of disruption that different severities and characteristics for these would occur within a particular category of “threat” scenarios would occur as a result of these different or “peril” – i. and business systems Long Depression. 1997 Asian Crisis likely to behave in non-intuitive ways. conservative. It is a challenge to develop a scenario that is useful for Throughout history there have been many other a wide range of risk management applications. we explore the consequences of The Cambridge Risk Framework attempts to categorize a “Eurozone Meltdown” resulting from cascade of all potential causes of future shocks into a “Universal sovereign debt devaluations caused by the sequential Threat Taxonomy. A large economic or financial catastrophe seldom affects just one part of the system. and output. financial and economic crises. examples include the 1720 South Sea interactions and systems that it will affect. Fully examples where multiple forms of financial understanding the consequences of a scenario of this catastrophe have cascaded from one form of crisis type is problematic because of the complexity of the to the next. 1893 Bearing Bank Crisis.” We have reviewed more than exit of countries from a currency union. are applied to four financial portfolios: high-quality fixed income. This result was a systemic Figure 1:  Financial catastrophe “FinCat” taxonomy banking collapse that had worldwide implications that still remains to be solved across the globe. The historical record shows that multiple market catastrophes tend to occur at the same time and impacts cascade from one crisis to the next. In this scenario. The financial crisis started in the US as a sub-prime asset bubble but quickly spread to the banking sector where many major banks were left holding assets worth much less than had originally been estimated. The complicated nature of the various financial derivatives that were being sold made it difficult for traders to understand the true underlying value of the asset that was being purchased. 1873 The economic. 1929 that we are trying to understand in this process are Wall Street Crash and Depression. a scenario. surprising characteristics. a thousand years of history in order to identify the The analysis estimates losses to the real economy different causes of disruptive events. Within this universal threat framework we have developed a specified taxonomy for financial Developing a coherent scenario catastrophes. balanced. and exhibit and the 2008 Global Financial Crisis. Investment managers could apply these asset value The report Cambridge System Shock Risk Framework: changes to their own portfolio structures to see how A taxonomy of threats for macro-catastrophe risk the scenario would potentially affect their holdings. management (CCRS. Bubble. 7 . and aggressive. 2014) provides a full description The impacts of the different variants of this scenario of the methodology and taxonomy content. financial. Scenario design During this process we try to obtain insights into the interlinkages through using an extreme scenario.

contagion mechanisms imperfect approach. fixed income. these have been highlighted to Overall the scenario consequence estimation process provide inputs into optimal hedging strategies and retains elements of uncertainty. with additional assumptions standardized high-quality. Linking all the components assumptions. In real events. however. with further assumptions generating with iteration processes to align and improve additional uncertainty. their relative severities and the patterns of economic behaviour. into a coherent scenario is problematic to achieve and the process described in this report is one particular We believe it is important to create a robust and approach that has attempted to do this. The spread of asset equities. and have tried to achieve this through a detailed recording of the It is suboptimal in that the process is imprecise and one assumptions made. In the macroeconomic stages of the modelling. timeline. utilities. to boundaries of the models functionality. and many of the Process definition. sentiment The scenario provides a timeline and an estimation of the change of fundamental value in assets in an investment portfolio. the scenario is deterministic and to use them in modelling extreme events. The point. and by making use of sensitivity of compounded uncertainty at each successive stage and tests regarding the relative importance of one input the methodology of various aspects of any particular into another. calibrated from normal effects. insurance loss lines. market movements can sometimes appear random. Employment likely market movements that would occur if an event of this type started to manifest. to challenge assumptions of continuing status quo and to enable practitioners to benchmark their risk management procedures. of producing the scenario is to we are conscious that we are attempting to push understand the consequences in terms of their holistic macroeconomic models. Loss Estimation Use of the scenario by investment managers Impact on workforce. Uncertainty and precision Where there are obvious winners and losers by economic sector. applications of the scenario are achieved through this sectoral impacts.Cambridge Centre for Risk Studies This involves sequential processing of the scenario The outputs then feed the assessment of portfolio through several stages and sub-modelling exercises. An approximation selection process has the useful limits of these models and to identify the been adopted on the basis of expert elicitation. footprint. limited as it is. outcome that occur. performance. 8 . In fact. under passive management. be in the range of the 1-in-100 annual probability of occurrence worldwide. Sectoral & regional productivity loss on key These provide insights for investment managers into metrics such as GDP. and the introduction of uncertainty and variation. making a number of assumptions to assess losses and direct impacts. These are segmented into broad asset classes and geographical markets to provide Macroeconomic Modelling indicative directional movements. transparent estimation process. does provide interesting insights. but not rigorously determined. These are then used as inputs within a This report provides performance projections for a macroeconomic model. outside their comfort zone. We and is not designed to provide exceedance probability have worked closely with economists to understand data points. finance. Market Impact Assessment This analysis suggests how the underlying fundamentals are likely to change over time. Scenario Definition The scenario production process. due to Valuation of key asset classes. The process entails portfolio diversification structures. such as the macroeconomic influences. fixed income portfolio. scenario needs to be understood in this context. FX class and geographical distributions enable investors to consider how different portfolio structures would perform under these conditions and how to develop Figure 2:  Structural modelling methodology to strategies for portfolio management that will develop a coherent stress test scenario minimize the losses that might occur. The scenario is offered as a stress test. supply chains.

to help a non-specialist audience understand the potential for events of this International agencies like The World Bank. 9 . National governments. causing severe scenarios. Many banks also carry out stress tests as part of their own internal risk management processes. It offers a view of the economic environment and broader financial disruption that will be caused. Development (OECD) and G7-G8 Group Meetings recognise the serious global implications of market- based catastrophe. and cause losses in unexpected ways and places. disrupting the interrelationships that drive business. Such tests are designed as an early detection system to identify vulnerabilities in the banking sector so that corrective action can be taken by regulators. and is offered as context for policy-makers concerned with stemming the impacts of market catastrophe. We also estimate returns for individual direct losses. central banks and other regulatory authorities including the Prudential Regulation Authority (PRA) in the UK use stress tests to determine whether banks have sufficient capital to withstand the impact of adverse economic developments. These stress tests focus on a few key risks such as credit risk. type to cause disruption and economic loss. In many cases. cascading effects on the how this scenario might impact their particular macroeconomy through trading relationships. market risk and liquidity risk. Thus. It is The International Monetary Fund (IMF). financial catastrophe. The stress test is aimed at providing an illustration of Use of the scenario by policy makers the effects of an extreme event. Scenario stress testing is a sensible and appropriate tool to improve the awareness and decision-making ability of policy advisors. as well as operational challenges asset classes to help investment managers consider to business continuity. This scenario is a contribution to the design of future versions of these policy-maker scenarios. financial market catastrophes are of interest because they represent complex risks – they impact the networks of activities that underpin the global economy. Complex risks and macroeconomic impacts Financial and economic systems are inextricably linked. banks are subject to performance reviews against classified versions of these scenarios and they are a mandatory requirement for many national regulatory authorities. It provides inputs into the decision making and resource planning of these authorities. The aimed at informing risk management decisions for a Organisation for Economic Co-operation and number of different communities of practice. This scenario is proposed as an addition to the existing frameworks and procedures that are already being used to understand risk and contagion in the global financial and economic systems. Eurozone Meltdown Stress Test Scenario This is to enable comparisons over time and between They have multiple consequences. and portfolio and to consider the intervention strategies on the capital markets and investment portfolios that over time that would mitigate the impact of this underpin the financial system.

trigger a default in that country in turn. in the debts. months of each other. Moody’s. such as interest rates and the collapse of global commodity Standard and Poor’s. This of defaults. Governments commonly lend to each other.e. Risk levels of sovereign bonds are reflected by Uruguay. difficult to borrow funds after a default event. It historically triggered wars between countries means that investors who hold the bonds issued by (see box) before the 1945 United Nations charter that country’s national treasury fail to receive the prohibited the use of force to enforce creditor nation promised payments and suffer reduced yields and rights. These regional cascades of defaults can be from a cascade of sovereign defaults in what are seen in the historical catalogues: in 1982 Argentina.Cambridge Centre for Risk Studies 3  Sovereign Default as a Financial Catastrophe Figure 3:  Risk Atlas illustrating global debt ratings across all nations. Brazil and Ecuador all defaulted within 12 investment instruments. along with those cities most at risk of sovereign default crisis (Cambridge Centre for Risk Studies) Sovereign default is a failure or refusal by a country’s Defaults from one country to another have even government to make a repayment of debts. prices were contributing common factors behind a number of sovereign defaults. particularly institutional investors Inter-government debt can be a cause of systemic and asset managers who tend to structure investment risk that triggers cascades of defaults and financial portfolios that contain a high proportion of fixed distress across multiple countries. 10 . including government economic hardship. Fitch. Neighbouring countries facing similar report explores the impact of unexpected devaluation economic problems may all default in a short period of fixed income assets in a portfolio resulting of time. likely and several countries who are reliant on each A sovereign default can mean a devaluation of the other’s’ loan repayments can be pushed into cascades principal. Within two years Venezuela. sovereign defaults become more treasury bonds from a basket of different countries. Peru and Chile had followed suit. low risk) Mexico. as this makes it much more expensive and worst case. However. and the failure of a country to repay its debts to another can National governments try hard not to default on their cause financial problems to the lender and. In times of income investment assets. conventionally regarded as high quality (i. closely linked with geopolitical events as well as Sovereign defaults can cause significant problems to financial and economic circumstances. private investors. High the ratings published by ratings agencies. as well as loss of yield from the bond. the risk of sovereign default remains potentially loss in value of the bond.

with the countries affected the affected countries and a falling stock market. attempts at fiscal prudence. mostly damages not only external creditors but also their economic factors that cause imbalance between domestic savers. Number of Countries in Default Cascade • popular unrest at austerity measures to repay debt fully. heavily have triggered protest movements and social unrest damaging the export-oriented German industry which have influenced politicians to moderate their making the country more like present Switzerland. have been voted out of office and replaced by anti- 8 austerity parties that promise to maintain public Number of Times in Past Century spending. 7 6 The various causes for countries to default include: 5 • major increases in public debt. Our scenario replicates a severe wave of sovereign Indirect reasons are the weaker growth prospects in defaults or currency exits. in particular. Somewhere in the world about once a year a leads to a downside pressure on the corresponding country defaults on its debts. to the Deutschmark.which would expose years there have been over 180 recorded sovereign them to the counterparty risk of a private bank . so national debt management has a high ECB currently runs many citizens call for a return to degree of political control. variants of increasingly severe and improbable the southern countries may see a redenomination of assumptions. but might be easier to sell to their national income and demands on their treasury. voters than adhering to a common currency that is Most governments borrow and maintain a balance of perceived as being controlled by external institutions. Of course. ranging from five countries that their debt and labour cost from Euro into their new contribute 6% of the world’s GDP. disregarding the advantages of Political pressure from the electorate can restrict a the common currency for the export revenues of the government’s ability to manage their debt. currencies. Negative scenarios for the market value of bonds – be it just for rising yields or even for an actual default – also weaken the currency these bonds are A History of Sovereign Defaults denominated in. through to all the own currency as a way to devalue this debt and cost countries in the Eurozone which accounts for 17% of and to push nominal growth rates. In the case of the Euro area. debt to fund longer term or strategic projects. country. and crises “Alternative für Deutschland” (AfD) calls for a return can occur that force unplanned financial shortfalls. though with fewer wealth reserves than its southern governments attempting to reduce national debts neighbour. Political reasons may force their own currencies. over the past century. over the past two hundred in the form of bank deposits . 1 0 • government regulation or perceived threats of 3 4 5 6 7 regulation of financial markets. The motives behind this strategy might be The period since the Great Financial Crisis of 2008 their voter base. One direct reason for this is that In the catalogue of financial crises compiled by foreign currency reserves are usually not stored Reinhart and Rogoff2. the global economy. After introduction of deficits by imposing highly unpopular austerity a new Deutschmark. 4 3 • reduction in tax receipts. which are mainly pensioners with has seen many countries attempting to reduce their little international experience. Selling these bonds century. In Germany. this comes at the cost of inflation and 2    Reinhart and Rogoff (2009) 11 . 2 • decline in employment levels. Figure 4:  Cascades of sovereign defaults by size (number of countries). all being major economies and issuers of investment A specific variant of exchange rate risk is grade sovereign bonds. Eurozone Meltdown Stress Test Scenario Countries default for a number of reasons. the governments to tolerate high levels of debt. which In northern countries which traditionally adhered to may include political change and restructuring of the a more conservative monetary policy than that the economy. These shifts in policy rise in value relative to the Euro and USD. with 120 of them occurring in the past in the form of sovereign bonds.but defaults. In some democracies. the new currency would likely measures on public spending. The scenario includes several redenomination risk.

the University of Cambridge their interbank lending patterns. have restored confidence in some instances. National economies and tests have little longevity and are quickly rendered banking systems have migrated from being individual obsolete. a number of candidate scenarios were reviewed in addition Long term historical observations may be a poor to the Eurozone cascading default. Likelihood and probability The risk that is the major concern of investment Assessing the probability of severity for a sovereign managers and financial risk analysts is the threat of default is complex. others fail with contention in financial circles. Their a modern severe stress that might fit the criteria of a default seems almost unthinkable. This includes Centre for Risk Studies has designed a new suite the flow of capital between countries. we observe would have to fail in order for the event to come that financial crises have increased in frequency since about. they Understanding this process is key to the risk have also failed to accurately capture the risk limits assessment of modern financial crises. In selecting the scenario for stress testing. or even perhaps ‘set the bar too low’ and require closer re-examination. though investment strategies across an international range improbable. global financial crises with a view to of financial assets and cross shareholding patterns test longevity. of the institutions whose financial health they seek Markets are increasingly correlated – their day- to diagnose. undergone a significant transformation in the past generation.Cambridge Centre for Risk Studies 4  Defining the Scenario The practice of using stress tests to check the health The interconnectedness of the modern financial of banks and economic institutions in the wake of the system has made markets more aligned and less Great Financial Crisis is currently a point of some independent. communication and transaction management also play a role. today than would be assessed by looking at the extremes from the past one or two centuries. once a century we have seen a cascade of six or seven countries defaulting in a single year. The potential for systemic ‘contagion’ of a financial crisis from one nation to another is driven by In light of this issue. of the four in the ownership of increasingly globalized financial designed. This particular scenario. globalization and financial deregulation in the last third of the twentieth century. the rapid rate of change in the to-day movements up and down are closer aligned economic climate means that results of such stress than they have ever been. In the compared with reasons why they were unlikely to companion volumes to this report being produced as occur. too poorly applied. In this period of general economic recovery markets with idiosyncratic behaviour to being part of there are concerns that current stress tests are too one global financial ecosystem. When one market fails. Historically individual countries sovereign defaults in some of the major economies of have defaulted at a rate of around one a year. One benchmark of havens of investment for fixed income returns. to identify what kind of control mechanisms part of our research into financial crises. explores the consequences of commodity institutions. Our stress test scenario is intended default in a single year. and it is a general ‘one-in-a-hundred’ annual probability event would be assumption that these investment instruments are a cascade of seven countries undergoing a sovereign completely safe. and the world. Recently. The most impactful scenario would be one in which the United States defaults – US treasury bonds are The likelihood of cascades of sovereign defaults – the one of the most popular investment instruments in ‘tail risk’ of extreme scenarios – is probably higher high quality portfolios. 12 . These cascades These are the bonds that are rated as investment have typically been in emerging markets or the grade by the ratings agencies and that provide the safe weaker economies of the world. predictable. While stress tests it in ways that did not occur before globalization. The shared philosophy and actions price spirals leading to a period of sustained high of central banks and technological advances in cost-push inflation worldwide. common of coherent stress tests to reflect potential. to challenge this assumption and to pose the question about risk levels inherent in investment grade However it is clear that the financial system has sovereign bonds. These were all benchmark for modern risk assessment.

the is negotiated to be completely dissolved. package. The order and sequencing Italy Italy Italy of the exits from the Euro are is especially important.0 of the Eurozone. In July 2015. Italy. Scenario variant S2 and extreme A market-driven meltdown of a Euro area willing variant X1 are similar to the standard scenario. an uncontrolled of a negotiated exit from the Euro area. Instead. The weak Euros without political the European Stability Mechanism (ESM) proved support become a significant economic risk. Ireland Ireland Ireland Instead. We test the severity of the US$4. anti-Euro parties spread into power quantitative easing (QE) firepower of the European even in Germany and France. We encourage parties towards the governments.9 Tn scenario through a number of variants. weakening the Euro. Greece Table 3:  Summary of dissolving countries from the and Spain) are caught up in a wave of defaults. Probability of Default In variant X1 we expand the scenario to a dissolution (%) 2. 5. In the southern worst-case scenarios. Greece. the willingness for any further unlimited Meltdown scenario to provide sensitivity analysis so financial support to their southern counterparty as to gain a better understanding of the greater effects decreases significantly. Many remaining countries with similar cultures would probably follow Germany to Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sept Oct build a new currency zone with strict monetary policy. 2013 2014 There are plausible extensions of the scenario that could go even further.0% some of the weaker European economies – Italy and the so-called PIGS (Italy. this may seem too extreme as a stress test area shows public political pressure from populist and its likelihood is extremely remote.2 Tn $10. we explore how populist parties also in France and Germany could trigger the end of the 3.8 Tn $12. Ireland. intense negotiations that concluded in a third-bailout Spain. and Ireland. Eurozone Meltdown Stress Test Scenario In variant S2. As of November 2015. Brussels is still blamed as cause for painful reforms the local governments were reluctant to Scenario Variants implement.0 coordinated rescue politics and the introduction of Annual parallel currencies. Greece Greece Greece as the functioning of the Euro system depends on Spain Spain Spain the commitment of the central countries France and Portugal Portugal Portugal Germany. scenarios focus on the rise of populist parties that challenge the consensus of the combination of rescue S1 S2 X1 architecture and reforms. Greek exit was barely avoided after several months of S1 consists of the peripheral countries. In variant S1. and that could potentially result in defaults of the mainstay investment instruments of Selected scenario US Treasury bonds and Japan government bonds. to pull United States Figure 5:  Annual probability of Italian default from 5 and potentially Japan into financial distress from year CDS spreads these events. hence it to overcome negative market forces. Euro area across the scenario variants 13 .3% 17. as the combined the populist. countries. We introduce a set of variants to the Eurozone To the North. the situation in the Euro However. Portugal. and ultimately the Central Bank (ECB) and the cheap funding from entire Eurozone. Total GDP (2013) The scenario spreads by political contagion across a number of countries. but to stay together seems unlikely. and evolving into their original currencies and further The scenarios selected reflect this political pressure. Portugal. although the investment risk managers to add assumptions about combination of the rescue architecture and political additional default likelihoods of US treasuries and reforms technically had worked well to decrease the Japan government bonds to their stress test for credit spreads from their 2012 highs. it is the political decisions in several Germany Germany countries to return to their own currencies to regain France France full spending control over their deficits that is the Rest of Eurozone most significant dimension of the scenario. exiting the Euro area.6% 14.

The new government and central banks respond by raising interest rates announces that it will no longer fulfil the Maastricht between 8-10%. too. a guaranteed extensive financial aid program to prevent MSE to default in the transition phase. support after submitting a robust rebuttal of the There is a surge in inflation in the exiting countries Chancellor’s demands. Anti-austerity rioting in Italy leads to the resignation Polls show that their governments will lose the of Prime Minister Renzi and triggers a snap general coming elections. declares that it is exiting Prime Minister Grillo gains widespread popular and devaluing its currency. which had been international markets into an even greater frenzy at gaining ground in the Italian senate. It leaves the Euro with a Phase 1: Five Star Italian Government comparable support package from the remaining member states. Portugal swiftly follows inform Italy that further servicing of Italy’s debt Spain’s example. Europe-wide.namely a substantial haircut. wins the election the suggestion that the Eurozone may be about to fall by a slight majority and forms a coalition with Lega apart. becomes Italy’s new prime minister. and 1000t of gold together with 10bn EUR and USD cash reserves . Markets react strongly to the 50% devaluation of Italian debt and foreign investment in Italy grinds to a halt. European Union authorities As the contagion spreads. Spain’s government is left with little option but to default on its debt. and Greece under pressure: their long- term bond yields explode and cut them off from the financial markets. Beppe Grillo. support package for Italy . sharply in reaction to heightened uncertainty and leader of M5S.Cambridge Centre for Risk Studies 5  The Scenario Background Silmultaneously. while the Euro itself initially welfare program. there are anti-European mass demonstrations in these fiscally insolvent countries. M5S. Voters perceive Italy as unfairly burdened with the Phase 3: Cascade of Defaults in the Weaker brunt of Europe’s current refugee crisis and the fear Trading Partners that the influx of illegal immigrants will draw down The shake-up immediately impacts the other native employment rates. Business and consumer confidence levels drop Nord. Italy’s most anti-European party. A sell off of Italian assets begins among the country’s major trading partners. election. The market value of Italian debt falls by 50% as a consequence of these measures. The announcement of the agreement also puts Spain. Dealt a blow by the rapid secession of measures as part of a coordinated effort to bolster European states. with Ireland doing the same will be contingent on the resumption of austerity within a week. so parties run on a platform vulnerable PIIGS nations. The remaining Phase 2: Nuova Lira eleven members of the Eurozone are dragged into a recession over the next ten fiscal quarters and stock The countries agree on an Italian exit with an extensive markets fall significantly in other major economies. Spain’s announcement sends The soft Eurosceptic party. Despite the election. 14 . Portugal. National exchange rates drop by up criteria but instead starting an extensive public to 40% against the support the new Italian currency. there is a sharp decline in equity prices. depreciates 15% against the dollar. Foreign markets begin to dump Eurobonds. Greece remains in the Eurozone for economic resilience. of economic reform and take a hard line against continuing austerity measures and kowtowing to Fearing a return to financial crisis and extreme German control of national finance policies. austerity. several weeks before it.

to examine how the global economy reacts subject to several sources of uncertainty. Country competitiveness is by more than half between 2002 and 2004 but. Forecasts outputs that cannot completely be ruled out. the default 0 1990 1995 2000 2005 2010 ($82bn) did not lead to any significant spread of contagion. the rise of an exchange rates.3 billion loan that 300 resulted in the country not being paid interest on a 200 loan payment. Eurozone Meltdown Stress Test Scenario 6  Macroeconomic Analysis Economic impacts of sovereign default Argentina GDP (US$ Billions) Sovereign default occurs when the government of a 700 sovereign state fails or refuses to pay back its debt 600 in full. The economy shrank all remaining countries. a quarterly-linked international econometric The modelling and analysis completed are also model. In Macroeconomic narrative of the scenario the short run output is determined by the demand The key indicators selected to simulate the effects of side of the economy. determined from unit labour cost. A recent and prominent example of sovereign default occurred during the course of this study in 500 Argentina which has defaulted twice on its debt in 400 13 years. interest rates and currency exchange rates. within two years. to 22. The grounds as well as following sound economic model contains a detailed database with historical theory and principles. 100 Despite being one of the largest sovereign defaults seen in the history of Latin America.5% in the year after the default. 15 . output and Sovereign Default are government debts. where central banks change nominal interest the unemployment rate from an average of 15%. Reasonably. Thus are updated monthly for the 5-year. capital stock and total factor productivity. adopting Keynesian principles in the short run and a monetarist viewpoint in the long run. and trade is the weighted average of alternative currency and the end of the peso’s fixed the growth in total imports of goods (excluding oil) of exchange rate to the US dollar. GDP growth returned to pre-crisis state and its economy began to grow at an average Assumptions and uncertainty annual rate of 9%. model. or the global economy. Macroeconomic effects of Sovereign Default Monetary policy is endogenised through the Taylor The previous Argentine default of 2001 had increased rule. Argentina’s economy is Figure 6:  Historical GDP data of Argentina from probably too small (less than one% of global GDP) 1990 to present (Source: World Bank) to render a significant financial collapse in Latin The Cobb-Douglas production function links the America. A best to shocks on the global economy. productivity and net foreign assets determine It also resulted in a new government. in rates in response to changes in inflation. (GEM). However. economy’s capacity (potential output) to the labour supply. 10-year and 25- final estimates represent a best attempt to model the year projections. short-term employment are determined by supply side factors. and in the long term. Argentina first defaulted in 2001 when the IMF refused to release a US$1. The economic estimates presented in this analysis are subject to the assumptions made in the development Oxford Economics Global Economic Model of the narrative and how the scenario may unfold We use the Oxford Economics Global Economic Model over time. the unusual and values of many economic variables and equations unprecedented nature of this particular catastrophe that describe the systemic interactions among the introduces several layers of uncertainty in final model most important 47 economies of the world. It is the most attempt has been made to ensure the macroeconomic widely used international macroeconomic model interpretation of the narrative is justified on historical with clients including the IMF and World Bank. economic outcomes of a low probability event with The Oxford GEM is best described as an eclectic highly uncertain outcomes. Relative the late 1990s.

Deutsche mark investors looking for better places to invest. Greece. Drachma • Debt value partially lost • High uncertainty over Spain. Punt default: • Numerous Quantitative • The Peso devalued by Easing programmes led Italy.4% in 1991 to 51% economic cycles in 19995 with other Eurozone Rest of Eurozone +30% +400% • Government forced members Rest of the World +10% • Debt cannot be to abandon fixed exchange rate. Rest of Eurozone 3 Long-term government bonds yields Portugal +50% +50% +50% 2001 Argentinian debt 2001 Argentinian debt Ireland default: default: • Long-term interest rates • Higher credit risks in Italy on borrowing increased the Eurozone Greece sharply9 • Increase in interest Spain rates on borrowing France • 4.Cambridge Centre for Risk Studies Macroeconomics input Scenario Variants S/N variables Justification for shock Scenario-specific assumptions key S1 S2 X1 1 Gross Government Debt (% of GDP) Portugal -50% -50% -50% 2001 Argentinian debt The Greek national debts6: Ireland default3: • 180% of GDP (2014) Italy • Defaulted debt of • Government revenue $155bn (largest in fell by 15% between Greece history)4 2007 and 2014 Spain • External debt-to-GDP • Misaligned budget France +25% ratio increased from imbalances and Germany +50% 28.3% of Greece’s GDP Germany was devoted to interest payments in 201410 Rest of Eurozone 4 Market Confidence (% points) Portugal -50 -50 -50 General market Specific examples: confidence affected by Portugal. Franc • Currency outflows- Germany. Escudo -25% -25% -35% 2001 Argentinian debt Weak euro8: Ireland.7%14 Table 4:  Catalogue of macroeconomic scenario assumptions made in the modelling process 16 . serviced 2 Exchange Rates (Against the Euro) Portugal. 2013 • Downgraded from BBB+ to BBB13 • Debt-to-GDP ratio of 133% • Low growth -1. 2008 decreases in11: • 200% external debt-to- • Credit ratingi GDP ratio12 • GDP by 10% • Government bonds • Investment by 30% rated ‘junk’ • Consumption by 15% Italy. Lira 70% against the dollar7 to a fall in the currency. Pesata euro currency. France.

Hornbeck. Kell. School of Social Sciences. A weak credit rating may lead to outflow of domestic funds. 4 Also known as “A decline without parallel”. Is Greek Debt Really Unsustainable? Social Europe Occassional Paper. Siegel.2%15 Spain • Credit rating BBB-16 France -10 Ireland. “Italy’s credit rating cut to BBB by S&P. J. Thus a good credit rating is important for a country to access funds in international capital markets. development of financial markets. 2014 Germany -10 • Sharp increase of debt- to-GDP ratio 114. July. January 2015 11 L. Jeff. 2015 10 A. “Devaluation – last option to save the euro”. Kearns. Portugal: 2008 Article IV Consultation—Staff Report. The Wall Street Journal. foreign investment. its balance of payment. Bloomberg. City University London. Gonzalez. ‘The Greek Euro Crisis is on the back burner . Tedesco. Margot. Argentina’s Defaulted Sovereign Debt: Dealing with the ‘Holdouts’. Eurozone Meltdown Stress Test Scenario Ireland Spain. “Will The Euro Get Weaker?”. 10 October 2012 17 J. Watt. public and private investment. Staff Statement. United States Congressional Research Service. Forbes. 2 August 2015 7 BBC News. A. 15 A. London. 12 February 2003 8 R. Barton. foreign currency reserves. Reuters. Or why history repeats itself”. 30 September 2013 16 BBC News. CIPEC. Altman. Baer. “Spain Credit Rating cut by S&P to BBB-”. outlook stays negative”. 27 April 2010 18 J. Public Information Notice on the Executive Board Discussion. and Statement by the Executive Director for Portugal. 2006 6 D. 2012/3 Italy • Debt-to-GDP ratio Greece 94. Q&A: Argentina’s economic crisis. October 2008 13 J. 2004 12 International Monetary Fund. Braun. The State Of Democracy In Latin America. Financial Review. and capital market transparency.8% Rest of Eurozone -10 -10 • High banking liabilities Rest of the World -5 -7 -10 Greece • Downgraded to ‘junk’17 • High capital withdrawals18 i Credit Rating provides investors some insight into how risky investment into a particular country is. 29 April 2015 9 W. Frye. It takes into account the performance of an economy as a whole. “S&P downgrades Greece to junk status”. 10 July 2013 14 Focus Economics. Table 4 (continued): Catalogue of macroeconomic scenario assumptions made in the modelling process 3 J. D. The Financial Times 22 May 2012 17 . 2 October. foreign debt. Argentina’s default and the lack of dire consequences.but next in line are Portugal. “Spain’s Public Debt to approach 100% of GDP end-2014”. Ruparel. Montes-Rojas.. ‘Italy Economic Output’. “The political economy of debt in Argentina. Italy And Spain”. G. 2010. 28 February 2002 5 M. Source: The Economist.

Defaults while in variants S2 and X1 the contagion spreads and/or the fear of default exacerbate the psychology. or debt defaults lasted between one and two years. The exact timing of the of credit loans from the capital markets. downward deflationary spiral. the sovereign default shock is (i. This scenario has included several independent Impact on inflation rates variants. Shock duration applied S1 S2 X1 1 Gross government debt -50% -50% -50% 1 Qtr 2 Market confidence -150% -150% -150% 5 Yrs 3 Exchange rate per Euro -60% -60% -60% 5 Yrs 4 Long-term interest rates +6% +4% +4% 5 Yrs 5 Defaulting Countries Portugal √ √ √ Ireland √ √ √ Italy √ √ √ Greece √ √ √ Spain √ √ √ France √ √ Germany √ √ Rest of Eurozone √ These shocks are chosen based on historical Results precedents. where partial of sustained currency depreciation for at least six or the full value is lost.Cambridge Centre for Risk Studies Table 5:  Key input variables and their maximum shocks applies to the respective scenario variants S/N Input Variable Scenario Variants Max. Some may even subsequently be restricted quarter of 2015 (Y0Q1). creditors had by the defaults to reflect the permanent Eurozone to accept renunciation of up to 75% of outstanding break-up. Although most of the past sovereign end up in partial or full debt cancellation. thereby severely damaging years. the reputation and credit ratings of the defaulting The model assumes the shock begins in the first nations. Furthermore. an immediate reduction on gross An example is the effect on exchange rates: historical government debts and interest payments. debts as Argentina disposed of its financial obligations. persist and last throughout the modelling period to represent the ongoing macroeconomic effects created During the Argentine default of 2001. Table 5 summarises the sentiment shifts into pessimism. to provide sensitivity analysis around the devaluation cannot be overstated. shock is not an important component of the model. Debts are data after the 2001 Argentina default shows a period retired by “restructuring” or default. such as the Argentine defaults in 2001 There are often many international negotiations that and 2014. the shocks restructuring prior to a nation defaults. less spending. nation. before engulfing the putting a downside pressure on prices and begin a rest of the Eurozone respectively. resulting in creditors. The market assumptions being made. consumers. savings). primary behavioural orientation into conservative In the S1 variant. lending. a currency crisis usually occurs and Variable Descriptions depreciates the currency value drastically.e. reducing the “velocity” of money. and borrowing and more mainly contained within the few defaulting nations. across to France and Germany. as market confidence levels take the but of more interest is the generic result showing the plummet and foreign investors avoid the defaulting potential impact on the wider economy. 18 . and investors to change their and spatial extent of Eurozone meltdown. modelled using the Oxford Economic The psychological aspect of credit crunch and currency GEM. maximum shocks applied to the key input variables debtors.

the S1 variant Eurozone compared to the baseline projection. the short-term interest rates consistently low and decreasing long-term interest (Figure 8) plummet to near zero in an attempt to expand 19 .0 3. across different sovereign default in the US will probably not occur as the government severities.0 4.0 -1.0 1. Conversely.0 2.0 0.0 2.0 1. S1.5 -9.0 2.0 -7.5 -3.0 1. Eurozone Meltdown Stress Test Scenario Eurozone Eurozone S1 S2 X1 Baseline S1 S2 X1 Baseline 3.0 -7.5 -3.0 0. the US measures several sovereign defaults.0 S1 S2 X1 Baseline 4.0 -1.5 Short-term interest rates (%) Inflation Rate (% year) 3.0 2.0 -5. the Eurozone further maintains low interest rates to encourage first experiences a sharp hike in inflation rates up to lending to boost the economy from the global 3% within the first year before it begins the downward disinflation and deflation scenarios.0 0. deflationary spiral up to -5% throughout the Long-term interest rates increase drastically in the modelling period. rise in the long-term interest rate is primarily due to Effect on interest rates the long-term uncertainty outlook in the economy and to compensate for additional risks associated with As Eurozone enters a deflationary spiral following the the Eurozone default.0 0. but results in a global disinflation and then sustains it at the trend is reversed in the US (Figure 9).0 Figure 7:  Eurozone and global inflation rates (% Figure 8:  Eurozone and US short-term interest rates year) comparison (%) comparison the money supply and encourage economic growth.0 Global United States S1 S2 X1 Baseline 3.0 1. In the standard scenario.5 1.0 1.5 Short-term interest rates (%) Inflation Rate (% year) 3.0 3. The sharp 0% throughout the modelling period.5 -5. Figure 7 compares both the Eurozone and the global Results also indicate that the projected QE tapering inflation rates.5 -9. On the other hand.

0 -12.0 -2. Germany and the Eurozone in their respective defaulting scenario variants. no credit rating is provided for Greece.0 16.0 8.0 United States Global S1 S2 X1 Baseline S1 S2 X1 Baseline 18.0 0.0 0.0 -10.0 2.0 6.0 -6.0 -2.0 2. market compared to the Eurozone in the near future.0 2.0 -12.0 0.0 12.0 16. By definition.0 Figure 9:  Eurozone and the US long-term interest Figure 10:  GDP growth rates (% qtr) comparison rates (%) comparison across the Eurozone and the global economy rates that reflect a marginally safer investment countries will not be meaningful in the analysis.0 -4.0 8. as credit ratings in the Oxford Economics Model are measured primarily through the proportion of gross government debts.0 -8.0 10.0 4.0 4.0 12.0 -10.0 -2.0 6.0 4. hence the new measured credit ratings of the defaulting 20 .0 Long-term interest rates (%) GDP growth rate (% qtr) 14.0 6.0 -6.0 6.0 -2. This is due to the transfer of the full or partial defaulted debts to other governments or additional debts incurred by these governments to bail out the defaulted ones.0 -4. However.0 2.0 8.0 8. Cambridge Centre for Risk Studies Eurozone Eurozone S1 S2 X1 Baseline S1 S2 X1 Baseline 18.0 Long-term interest rates (%) 14.0 GDP growth rate (% qtr) 4. In Table 6.0 -8. the defaulting countries have their sovereign debts “restructured” and interest payments reduced. credit ratings of non-defaulting countries are similarly affected. Effect on credit ratings It is clear that credit ratings of the defaulting countries suffer the largest downgrades.0 10.0 0.

negative GDP growth of up to 3% for six quarters) should the entire Eurozone defaults. This is expressed as a percentage of Table 6:  Credit ratings comparison across affected the total GDP projection for the five years without the countries and regions crisis occurring. to six quarters. in and interest rates are important factors influencing the extreme variant X1. The Global GDP@Risk global economy is also analysed to experience a deep 85 recession (i. approximately US$13 trillion. The primary figure representing the impact Greece C N/A N/A N/A of this catastrophe is the GDP@Risk. all have important effects on output and growth. which is the total Germany AAA BB N/A N/A difference in GDP between the baseline projections Eurozone AA BB N/A N/A and the scenario-specified projections. beginning in the Japan AA BBB BBB BBB first quarter of Year 0 (Y0Q1) during which the high United Kingdom AAA AA BB B inflation shock is applied and sustained through to the United States AAA AAA AA BB last quarter of Year 4 (Y4Q4). 65 Yr-2 Yr-1 Yr0 Yr1 Yr2 Yr3 Yr4 Yr5 Figure 11:  Estimated loss in global output as a result of sovereign default scenario variants 21 . other factors such as capital the world economy into a global recession that lasts up flight. Table 7 provides the GDP loss of each of the countries. While changes in exchange rates. and as the GDP@Risk. the five defaulting countries resulted in a Eurozone as well as the global economy. we recession (see Figure 10) that last slightly over a year have shown how sovereign defaults that take place after the default cascade. which contribute more US$ Tn 75 than half of the global GDP loss over this period. is expected to cost up to 6% of the expected global The impacts on each variant of this scenario are GDP output. The GDP@Risk over the five-year period model is a five-year forecast for the world economy. The Baseline GDP losses in the US and Eurozone are substantial. more significantly in the S1 and S2 variants. Eurozone Meltdown Stress Test Scenario Minimum Credit Rating compared with the macroeconomic baseline projection Location of the global economy under the condition of no crises Baseline S1 S2 X1 occurring. inflation not quantifiable as a “global” recession. unemployment and existing government debt levels. The output from the variants. across downgrade across the remaining non-defaulting variants. Effect on economic growth rates The technical indicator of a recession is two consecutive Economic conclusions quarters of negative economic growth commonly A Eurozone Meltdown scenario clearly has very measured by a country’s GDP. In standard scenario significant implications for the defaulting countries S1. the trajectories of global GDP show the 70 closing of the gaps in GDP caused by the Eurozone meltdown towards the end of the 5-year shock period. With the restructured debts passed on to other Figure 11 illustrates the dip in global GDP that is governments. the Eurozone default plunges economic output. weak market confidence and pessimism. variants of the scenario. defines the GDP@Risk for this scenario. we observe a collective credit rating modelled to occur as a result of the scenario. However. both as the total lost economic output over five years. China AA AA BBB BBB The total GDP loss over five years. such as the UK and the US. GDP@Risk The impact severity and extent of this scenario result The macroeconomic consequences of this scenario are in recessions across different economies and model modelled using the Oxford GEM. in the projected baseline scenario. S1 S2 The total cost of the scenario to the global economy is 80 X1 estimated to be between US$11 and US$23 trillion.e. In this analysis. within a small geographical region can spread The same scenario sees a reduction in global economic around the world and affect almost every other major growth to almost zero for less than two quarters but is economy. However.

88 13.03 0.3% 0.61 1.0 11.0% 4.0% Eurozone 67.33 1.24 5.22 16.6% 0.2% 4.24 2.9% 1.9% Germany 19.26 4.1% 4.2% 0.7% World 395.8% United States 88.72 3.3 0.16 11.1% 23.39 9.17 6.0 1.9 2.6% 0.3% China 48.95 5.62 5.72 7.1 0.4 -0.1 4.1% 0.78 4.1% 0.8% 16.2% United Kingdom 14.91 7.62 9.95 5.1% 0.3% Japan 29.34 16.9% Table 7:  Effect of global property crash on minimum GDP growth rates comparison 22 .24 17.65 2.3 0.2% 8.Cambridge Centre for Risk Studies Baseline S1 S2 X1 5-yr GDP GDP@Risk GDP@Risk GDP@Risk GDP@Risk GDP@Risk GDP@Risk Location (US$ Tn) (US$ Tn) (%) (US$ Tn) (%) (US$ Tn) (%) Greece 1.08 -0.47 1.5% 2.0% 0.

We built a fictional representative portfolio that mimics features observed in the investment strategies of insurance companies. Figure 13 and Figure 14. Details of the High Fixed Income Portfolio are shown Valuation fundamentals on the following page in Table 8. alternatives and equities in the US. This analysis is not a prediction of daily and Figure 17. This assumption is unrealistic. Figure 21. It is however a useful exercise to consider what would happen to a fixed portfolio. UK. Note that this is an estimate of how the fundamentals of asset values are likely to change as a result of Details of the Conservative Portfolio are shown on these market conditions. as we expect an asset manager to react to changing market conditions in order to reduce losses and large fluctuations in returns. Figure 12. Figure 19 and values due to trading fluctuations. Germany and Japan. FTSE the scenario and the consequence for investors in the 100 (FTSE). Understanding what drives the behaviour of the fixed portfolio at different times gives useful insight towards the design of an optimal investment strategy. sentiment and the Figure 20. Residential Mortgage Backed Securities (RMBS) make up 5 % of the Conservative Portfolio structure. A standardized investment portfolio We access the performance of four typical high quality investment portfolios under the Eurozone Meltdown scenario. Eurozone and Japan. Balanced and Aggressive. and compared with a baseline projection of while short-term bonds have a maturity of 2 years in their expected performance that would result from the each country. We will assume for simplicity that equity scenario will have an inevitable effect on the capital investments correspond to investments in stock markets. respectively. stocks are used to represent equity investments in The performance of bonds. 23 . Details of the Aggressive Income Portfolio are shown Passive investor assumption on the following page in Table 11. Figure 18. Eurozone Meltdown Stress Test Scenario 7  Impact on Investment Portfolio Introduction Investments are spread across the US. market behaviour and does not take into account the Details of the Balanced Portfolio are shown on the wide variations and volatility that can occur to asset following page in Table 10. For example the Conservative Portfolio structure has 55% of investments in sovereign and corporate bonds. in particular because this represents a benchmark against which to compare the performance of dynamic strategies. Figure 15. UK. This section considers the market impact of indexes. of which 95% are rated A or higher (investment grade). economic projection without the scenario occurring. The Wilshire 5000 Index (W5000) . DAX (DAX) and Nikkei 225 (N225) capital markets. Figure 22 and Figure 23. Figure 16 valuation. outputs. mechanisms of the market. We different markets are estimated from the macroeconomic assume a maturity of 10 years for long-term bonds. Equities compose 40% of the Conservative The macroeconomic effects of the Eurozone Meltdown Portfolio. titled High Fixed Income Portfolio and three others that mimic the investment strategies of pension funds titled Conservative. as directional indication of the following page in Table 9. A fundamental assumption we make in our analysis is that of considering a passive investment strategy.

Bonds 10yr 6% 7% 3% 2% 18% Corp.0% US Euro 41.5% 0.0% Equities yr 4.0% USD 35.0% RMBS 10 yr Corporate 2 yr 2.0% 10.Cambridge Centre for Risk Studies High Fixed Income portfolio structure Conservative portfolio structure USD GBP Euro Yen Total USD GBP Euro Yen Total Government 2 yr 8% 6% 5% 3% 22% Government 2 yr 4% 3% 3% 0% 10% Government 10 yr 8% 7% 6% 2% 23% Government 10 yr 3% 3% 3% 1% 10% Corp.0% 29.5% RMBS 2 yr Corporate 10 yr 14.0% 23.0% Government 2 10.5% 0% 2. Bonds 2yr 4% 4% 4% 2% 14% Corp.0% 23.0% RMBS 2 yr 5.5% 17.0% Euro 25. Bonds 10yr 6% 5% 5% 1.0% yr Government 10 RMBS 10 yr 22.5% RMBS 10 yr 1% 1% 1% 1% 4% RMBS 10 yr 1.5% 18.5% 17.0% 40.0% 9.5% 0% 2.5% 17.5% 0.0% Government 10 Corporate 2 yr Corporate 10 yr yr 17.5% Equities 2% 3% 3% 2% 10% Equities 19% 8% 8% 5% 40% Cash 4% 0% 0% 0% 4% Cash 0% 0% 0% 0% 0% Total 35% 29% 23% 13% 100% Total 41% 25% 25% 9% 100% Table 8:  Composition of the High Fixed Income Table 9:  Composition of the Conservative Portfolio Portfolio Structure Structure Cash Equity 4% 10% Equity Alternatives 40% 9% Fixed Income 55% Fixed Income 77% Alternatives 5% Figure 12:  Asset classes in High Fixed Income Figure 15:  Asset classes in Conservative Portfolio Portfolio Structure Structure Yen Yen 13.5% Figure 14:  Detailed asset class breakdown of High Figure 17:  Detailed asset class breakdown of the Fixed Income Portfolio Structure Conservative Portfolio Structure 24 .5% Corp.5% 0.0% 10.5% 0.0% Figure 13:  Geographic market spread of High Fixed Figure 16:  Geographic market spread of Income Portfolio Structure Conservative Portfolio Structure Cash Government 2 yr Equities 4.5% RMBS 2 yr 2% 1% 1% 1% 5% RMBS 2 yr 1. Bonds 2yr 6% 5% 5% 1.0% GBP GBP 25.0% 2.

5% Corporate 2 yr 50.5% 4% Government 10 yr 3% 3% 3% 1% 10% Government 10 yr 1.5% 0% 9% Corp.0% US 45.5% Corporate 10 yr 9.0% yr Government 10 4.0% Euro 23.5% 2% 13% Corp.5% 2.0% 13.5% 7.0% RMBS 10 yr RMBS 2 yr 7.0% RMBS 2 yr 7.5% 0.0% 23.0% 5.5% 3.0% 23.5% RMBS 2 yr 2.0% yr Corporate 2 yr 10.5% RMBS 10 yr5.0% 4.5% 8. Bonds 2yr 3% 2. Eurozone Meltdown Stress Test Scenario Balanced portfolio structure Aggressive portfolio structure USD GBP Euro Yen Total USD GBP Euro Yen Total Government 2 yr 3% 2% 2% 1% 8% Government 2 yr 1.5% Equities 25% 10% 10% 5% 50% Equities 30% 12% 12% 6% 60% Cash 0% 0% 0% 0% 0% Cash 0% 0% 0% 0% 0% Total 44% 23% 23% 10% 100% Total 45% 23% 23% 9% 100% Table 10:  Composition of the Balanced Portfolio Table 11:  Composition of the Aggressive Portfolio Structure Structure Fixed Income Fixed Income 40% 25% Equity 50% Equity 60% Alternatives 15% Alternatives 10% Figure 18:  Asset classes in Balanced Portfolio Figure 21:  Asset classes in Aggressive Portfolio Structure Structure Yen Yen 9. Bonds 10yr 3% 2.5% 1% 1% 0. Bonds 10yr 4% 2.5% 8.5% 7.5% Corporate 10 yr Equities 8.5% 5% RMBS 10 yr 3% 2% 2% 0.0% Figure 19:  Geographic market spread of Balanced Figure 22:  Geographic market spread of Aggressive Portfolio Structure Portfolio Structure Government 2 yr Government 2 yrGovernment 10 8.5% 1% 1% 0.5% 5% RMBS 2 yr 3% 2% 2% 0.5% 2.5% 2.5% Corp.0% 10.0% US Euro 44.0% GBP GBP 23.0% Equities 60.0% 8.5% RMBS 10 yr 2.5% 1% 1% 0. Bonds 2yr 4% 3.5% 0.5% 1% 1% 0.5% 4% Corp.0% Figure 20:  Detailed asset class breakdown of Figure 23:  Detailed asset class breakdown of Balanced Portfolio Structure Aggressive Portfolio Structure 25 .

097% B 1.12% 4. we see the portfolio begin of the sovereign bond restructuring cases since 1997. to recover. S1 Spain.108% output of the macroeconomic analysis discussed in the previous chapter.56% 46. The 2008 volume-weight corporate Greece. 2005. see Table 12. default rates from Moody’s are shown in Table 13. we take into account default on government bonds.370% change in credit spreads. The overall haircuts applied to the Euro and UK This implies that investments in heavy equity government bonds are calculated as a weight average portfolios will yield the worst returns.816% on government and corporate bonds and the A 2. bonds In our analysis. used to increase the 2008 default rates severity for X1 9.019% representative quarterly yield. we Figure 25 shows the scenario variant impacts by average several less severe cases. and for corporate bonds and RMBS using equation (2). scenario.8 for two years bonds. For the Eurozone Metldown that Euro and UK sovereign bonds receive a haircut scenario. for which we assumed t h e following values: =7 for ten years bonds Bond Credit Rating Corporate and =1. are taken from the BBB 1. (2) Portfolio returns Where is the bond duration. The maximum downturn experienced for To calculate the% haircut for 2 year bonds we average the Conservative portfolio in the S1 variant is -9.287% Government bond yields are estimated using a CCC 11.89% 18. In all variants extensions. we will assume that the defaulted For the Eurozone Meltdown scenario the economic governments will use haircuts to transform their shocks were applied over a five year period starting debt. There are three common Results of our analysis are presented in Figure 24 transformations of debt when a government Figure 25. we see the aggressive portfolio structure of 63% for 2 year bonds and 31% for 10 year bonds. represents AAA 0. Haircuts on bond principal were seen in 45% in Yr1Q1.86% 7.000% t h e spread duration. underperform compared with the other structures. The equity dividends are estimated using calculated for all government bonds using equation (1) a representative quarterly yield. Portugal 0% 0% 14. Defaults on corporate bonds are accounted for 26 .10% 23. AA 0. the most common being maturity the Conservative portfolio structure. of the % GDP contribution that each default country contributes to the Eurozone as a whole. we assume portfolio structure. Italy. we observe a significant departure from the baseline Given the severity of this Eurozone Meltdown (blue line) projections. Thus. Equities market prices are calculated using the Computation of returns change in equity value from the macroeconomic Market price changes or Mark to Market (MtM) are modelling. BB 8.94% credit rating and geographic regions. Exchange rate affects are taken into to account to (1) ensure that all reported portfolio returns are with respect to US dollars.Cambridge Centre for Risk Studies Scenario Default UK UK Euro Euro through the introduction of a discount factor in the Countries 2 yr 10 yr 2 yr 10 yr calculations. A multiplier was All of Eurozone. To calculate the% haircut for 10 year bonds. While corporate and RMBS yields are estimated using a representative Table 13:  Annual default probabilities for corporate quarterly yield and the period averaged credit spread. coupon reductions and Figure 24 shows the scenario impacts by variant for nominal haircuts. defaults: maturity extensions.05% the Eurozone Meltdown scenario.43% and Ireland The actual corporate bond default rates used were calculated as the weighted average of default rates by Plus France S2 and Germany 0% 0% 37. The change in interest rates.86% the four largest haircuts on government bonds since nominal occurs in Yr1Q2. After three years. It is safe to assume including UK that corporate bonds were be heavily impacted in a Table 12:  Sovereign Bond Haircut Rates Eurozone Meltdown scenario. Figure 26 and Figure 27.

41% in the least extreme variant. of the nodes represent asset returns in relation to the Interestingly. Analytics (FNA) is used to monitor market dynamics The analysis presented in this section assumes for each scenario. with a loss of A new market analytics tool called Financial Network -13. Summary of investment portfolio analysis S1. all the stocks are performing Shorter links represent strong correlations. while it is only over different portfolio structures.09% -1. Nominal % -0.64% -13. while the US is least the output from the macroeconomic model and used impacted. Over the three year analysis window. We have estimated 10% for fixed income. Conservative Portfolio (nominal %) downturn by portfolio structures in nominal % 15% Fixed Income Performance. performance by geography for the most least variant. Although. variant. starts generating positive returns after three years. This confirms the finding that the performance of the portfolio under the different a high fixed income portfolio performs better than a variants of the Eurozone Meltdown scenario and high equity structure. compared it with the business as usual performance or baseline.62% 5% -5. the Euro (DAX) stock is impacted the most.85% -28.23% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Yr1 Yr2 Yr3 High Fixed Income Conservative Balanced Aggressive US Euro UK Japan Figure 25:  Eurozone Meltdown scenario maximum Figure 27:  Eurozone Meltdown High Fixed Income downturn by portfolio structures in nominal % portfolio performance by geography in nominal % for S1 Figure 26 shows market impacts on equity Assets in the Conservative portfolio are shown performance by geography for the least extreme as nodes and the correlations are shown as links.41% -15.02% -1.86% 0% -11. 27 .33% -32.38% -15% -35.42% -9. Nodes that are coloured red represent a negative Figure 27 shows the market impact on fixed income correlation and thus negative asset returns. S1.04% -10% -27.72% -18. it for a pre-scenario and post-scenario view. The Aggressive portfolio structure Correlation Structure performs the worst in this scenario. the Japanese (N225) stock index is portfolio. German fixed income bonds are impacted the most.53% -31. see Figure represents a useful benchmark to compare more 28 and Figure 29 on the following page. the larger the node the larger the return.87% -1. S1. The largest negative impact to a single it as an input to assess the performance of the four equity asset is greater than 55%. A daily correlation map was created a passive investment strategy. Japan is In this part of the scenario analysis we have taken also yeilding negative returns. Eurozone Meltdown Stress Test Scenario 10% 10% 5% Equity Performance. The size poorly. Nominal % 0% 0% -10% -5% -20% -10% -30% -15% -40% -20% -50% -25% -60% -30% -70% Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Yr0 Yr1 Yr2 Yr3 Yr1 Yr2 Yr3 BASELINE (Nominal) S1 (Nominal) S2 (Nominal) X1 (Nominal) US-W5000 Euro-DAX UK-FTSE100 Japan-N225 Figure 24:  Eurozone Meltdown scenario impact by Figure 26:  Eurozone Meltdown scenario maximum variant. Nominal % Baseline S1 S2 X1 10% Total Portfolio Returns. Nonetheless.18% -5% -25. asset management strategies.

Baseline S1 S2 X1 High Fixed Income -2% -5% -16% -18% Conservative -1% -10% -25% -28% Balanced -1% -12% -29% -31% Aggressive -1% -13% -32% -35% Table 14:  Summary of portfolio performance (max downturn) by structure and scenario variant. This is to a certain degree taken into account given that we considered different variants of the scenario. Table 14 summarises the max downturn by portfolio structure and scenario variant. nominal %.Cambridge Centre for Risk Studies In particular. but a more systematic analysis will be needed in this respect. Figure 28:  Conservative Portfolio before stress test Figure 29:  Conservative Portfolio after stress test 28 . it can be used to discuss strategies that improve portfolio performance on a counterfactual basis under the scenario. An important issue that we have not addressed in our analysis is that of systematically testing the stability of the results with respect to the parameter settings used in the earlier stages of the scenario development.

in real %. 29 . Eurozone Meltdown Stress Test Scenario Short-Term Impact at Long-Term Impact at REAL USD PERCENTAGE Yr1Q4 Yr3Q4 VALUES Baseline Baseline Yr1Q4 S1 S2 X1 Yr3Q4 S1 S2 X1 US Gov Bonds Short 2 yr -1% 0% 0% 0% -6% 1% 2% 2% Gov Bonds Long 10 yr -1% 2% 2% 2% -9% 13% 14% 14% Corp Bonds Short 2 yr 0% 1% 0% 0% -2% 3% 4% 3% Corp Bonds Long 10 yr 1% 3% 3% 2% -4% 16% 16% 14% RMBS Short 2 yr 0% 1% 1% 1% -2% 5% 6% 7% RMBS Long 10 yr 0% 3% 3% 2% -6% 16% 17% 16% Equities W5000 8% -4% -10% -15% 15% -2% -15% -39% UK Gov Bonds Short 2 yr -5% -2% -4% -13% -9% 4% 2% -22% Gov Bonds Long 10 yr -6% -3% -18% -22% -13% 5% -8% -19% Corp Bonds Short 2 yr -4% -3% -5% -5% -8% 4% 2% 2% Corp Bonds Long 10 yr -5% -3% -18% -19% -11% 6% -7% -7% RMBS Short 2 yr -5% -2% -3% -3% -8% 6% 5% 7% RMBS Long 10 yr -6% -2% -18% -18% -12% 8% -5% -4% Equities FTSE100 5% -21% -36% -43% 24% -27% -41% -61% EU (Germany) Gov Bonds Short 2 yr 0% -18% -61% -64% -2% -36% -76% -82% Gov Bonds Long 10 yr 0% -13% -68% -70% -7% -18% -65% -69% Corp Bonds Short 2 yr 2% -5% -43% -44% 2% 1% -21% -21% Corp Bonds Long 10 yr 3% -6% -63% -63% -1% 5% -34% -34% RMBS Short 2 yr -5% -3% -42% -42% -8% 6% -16% -15% RMBS Long 10 yr -5% -5% -63% -63% -12% 8% -31% -30% Equities DAX 3% -44% -98% -98% 12% -29% -66% -68% Japan Gov Bonds Short 2 yr -9% -8% -8% -8% -18% -10% -10% -10% Gov Bonds Long 10 yr -8% -6% -6% -6% -20% -8% -8% -7% Corp Bonds Short 2 yr -9% -8% -8% -8% -18% -11% -11% -11% Corp Bonds Long 10 yr -8% -6% -6% -7% -20% -9% -8% -9% RMBS Short 2 yr -9% -8% -8% -8% -16% -10% -10% -10% RMBS Long 10 yr -8% -6% -6% -6% -17% -8% -8% -8% Equities N225 -2% -5% -7% -9% -5% 2% 1% -1% Table 15:  High Inflation World summary of asset class performance by variant and geography.

governments. but also for European and global involvement” of private creditors to Greece in early investors. For example.Cambridge Centre for Risk Studies 8  Mitigation and Conclusions Possible prevention or mitigation strategies of the This is a form of basis risk due to the legal uncertainties described risk potential is a concern for European of sovereign risks. From 2011 to 2015. The lead is with the EU commission. as their payout depends on a formal credit event. Italy is allows to hedge sovereign bond risks of the largest economically divided between the north and the south. However. Holders of the bonds who also owned credit the EU institutions. rather than those issued under English law (BIS European financial policies are usually prepared by 2012). The clearing and collateral systems of of Germany. the “private sector policymakers. If the insured bonds lose market value and need to be sold before a formal default to combat investment constraints. Euro area issuers Germany. the choice of the bank rescue mechanisms were installed that successfully counterparty to execute FX transactions might be addressed the problems of market-driven default risk crucial as the described scenarios might also involve and high funding cost for the southern countries at the default of international banks. equity markets and balance magnitude and likelihood of impact. 30 . which is the EU commission. early warning indicators of European voters. ISDA after the collective action clause was executed The national governments often lack to show public by a large majority of bondholders. and the Euro group of finance (CAC) to be included retroactively although the ministers which are direct delegates of their nations’ process would weaken the credit’s market value. In the case of sharp losses in the market populist parties in the north of Italy tend to present the value of core European bonds. Switzerland and Austria and a southern the futures exchanges proved to work smoothly even part that depends on transfer payments. a shortage of collateral EU as being the reason for necessary reforms to increase and large imposed haircuts on the accepted bonds are competitiveness. tools for damage mitigation rather than pointers to public spending and economic growth is necessary. comprehensive risk solutions. For example. large commodity shocks are not sufficiently reliable to act upon without affecting risk profile. Global diversification is not a able to withstand a 1-in-100 year catastrophe?” and simple solution to this problem as other geographic “What would I do to improve the resilience of my regions have their own specific problems. the described scenario involves substantial market Stress tests such as the High Inflation World Scenario risk in fixed income securities. whether due to “Mother Nature” or a market or leading to little acceptance at the level of the national macroeconomic episode. However. little direct cost for the northern countries. Indeed we advocate European parliamentarians should contribute in that recognition of catastrophic events entails defending the EU policies in their home countries. France and Italy via with the north being similarly competitive than the south liquid futures. derivatives pushed for a “collective action clause” the EU parliament. not their own failure in developing the to be expected. especially in the From the viewpoint of a European or global investor. recognition of substantial losses. during 2008. The organisation to such a shock?” hedging properties of sovereign credit derivatives are questionable. a credit event was only determined by which also forms the public picture about the EU. southern part of their own country. “Is my organisation formal default event. For the main European equity indices. funding cost. short term. Warning A better communication strategy which explains the signs are therefore only inputs to risk management strong links between competitiveness. could not successfully communicate this equilibrium. However. even if there is no facilitate questions such as. a combination of reforms and For the currency risk. loyalty towards their voters concerning the common The existence of a liquid market of listed futures decisions made on EU level. and the external value of the Euro. 2012 only involved bonds issued under Greek law. the EU institutions that executed these programmes Given the unpredictability of high impact events. the increase in market value of the credit derivative might not fully cover the overall loss. also liquid futures contracts are available.

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