Sovereign Danger: What is Sovereign Danger
Sovereign risk is the chance that the national government’s treasury or central bank will default on its sovereign debt or impose foreign exchange rules or restrictions that will significantly reduce or deny the value of its foreign exchange contract.
Sovereign risk means that the government of a country is likely to default due to its failure to pay the interest or principal of its sovereign debt.
Sovereign risk is traditionally low, but it can hurt investors in bonds whose issuers are experiencing a financial crisis and can lead to a sovereign debt crisis.
Strong central banks can reduce the perceived and real risk of government debt by reducing the cost of borrowing for those countries.
Sovereign risk can directly affect foreign exchange traders holding contracts that exchange the currency of that country.
Understanding universal risk
The sovereign risk is the possibility that the foreign country will fail to repay the debt or will respect the sovereign debt payments or obligations. In addition to the risk to sovereign debt bondholders, sovereign risk is one of the unique risks faced by the investor when entering into a foreign investment contract (other such risks include currency exchange risk, interest rate risk and liquidity risk). Sovereign risk comes in many forms, although anyone who faces a sovereign risk experiences the risk in one way or another in a foreign country.
Foreign exchange traders and investors face the risk that the foreign central bank will change its monetary policy, which will affect currency trading. For example, if a country decides to change its policy from a pegged currency to a float currency, it will change the benefits to currency traders.
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