What position should Jason Sterling take on European sovereign debt? Why? What are the advantages/disadvantages of using credit default swaps to profit from this crisis? What are the potential risks? Are there any lessons for Jason that can be gleaned from previous crises?
The aim of Jason Sterling is to assess novel information so that he has the ability to trade on prior to the trading close for the week period. This was because the growing debt crisis in the sovereignty of the Europe would be the hot topic or the primary notion that the leaders and representatives from the global scene would be talking about. There needs to be a confirmation to him that there is a solution that can be prescribed by the leaders of Europe regarding the current situation of crisis. If there is an expectation that a solution can indeed be prescribed by the leader, there should be taking of the buying position by Jason. On the other hand, if there is no formulation of a possible solution in near time, there could be total turmoil in the market of sovereign debt. This is when Jason should give up the decision or position of buying.
The advantage of using credit default swaps is that it protects the buyer from the risk of loss during the trading period. By using the credit default swap, the buyer’s exposure will be limited and he can invest in the riskier ventures, which he would have ignored otherwise. If Jason buys the credit default swap, then he will have to pay only interest on the value of swap to the swap seller. However, this protects Jason from losing all of his investment if the debt issuer defaults. If Jason issues credit default swap, then he will get the fees or interest from the swap buyer. While the disadvantage of having the credit default swap is that one need to pay interest periodically on the total value of the swap even when the issuer do not default. The buyer of the credit default swap will lose money in the form of interest paid to the seller of the credit default swap. But, by having a credit default swap, Jason can get protected when there is a default from one and by selling the credit default swap, Jason will get interest from other swaps even when he have to pay for some defaults.
Generally, the debt holder would prefer to have the credit default swap when the value of debt is too big and the default of which will have very strong impact on the performance of the bondholder. To protect from such hazard that might come as a result of default, the firm or a company buys credit default swap. So, the potential risk associated with such is that the issuer of the credit default swap might not be able to afford the payment of such a big debts in case of the default. The issuer of the credit default swap might come as a defaulter because of the inability to afford for the payment of the defaulted value. Jason can take insights from the previous crises. From the crisis of the Greece, there was deficit and increasing payments of the interest. There was also the high risk of default. So, the Jason must understand that such situations arise. Even the developed economies face the problem of crisis and the default can occur from any type of organization. What he can learn is that he must be prepared for such instances by purchasing appropriate hedging instrument to protect oneself from such losses.
2. Where do the problems in the euro zone seem to originate from? Is the euro zone an optimal currency area? Why or why not?
The problems that the Euro zone has been currently facing and especially because of Greece, have been put on to the lack of Euro zone having a proper fiscal policy (Elliott, 2015). The conclusion of the problem analysis suggests that in the past five years, the members of the zone have been giving heavy prices for the lagging of common system in relation of transfer of resources from a given part where currency is single to some other area. There is just one currency and a single interest rate that the total zone follows, however there is absence of the fiscal union which results in lag of monetary union standing. Thus, Euro Zone can also not be called optimal currency zone.
3. What role have financial institutions played in the sovereign debt crisis? How will their involvement affect negotiations among European leaders about potential solutions?
The security of buyer risks in the time of trading is the major advantage of making the use of swaps of credit defaults. Due to the heavy exposure, there is limitation when it comes to time to time premium rather than taking into account any prospective rise in the prices of bonds. There is also certain disadvantage associated with the credit default swaps. One of them is that when there was a default in the CDS that had been purchased for a particular nation, the payment receipt would be on lump sum basis. In cases where there needed to be the selling of a CDS, there would be periodic payments to his funds and he had to make the payments in cases where there was a default in the assets of the issuers. Thus, the risk potential lies in the event of credit default. In this case, the issuers of CDS cannot have the affordability of paying back to the buyers. Accruing to the crisis in Greece, there were many deficits being faced, with substantial increase in the payments of interests and the possibility of being involved in a debt default.
4. How do the ESM and EFSF address the sovereign debt crisis? What issues do they miss?
The European Stabilization Mechanism, also known as the ESM, is one the tools for the addressing of debt crisis at the sovereignty levels. It gives allowance to the European Commission for the raising of funds by the issuance of bonds keeping the individual budget as a form of collateral. Then there is forwarding of these created funds into the economy of nations which are in struggling phase.
There was issue of bonds from the European Financial Stability Facility, also known as the EFSF. The distribution of the proceeds then happens to the countries of euro zone which are in fund requirements. The interest rate in the whole process is determined from the IMF model. The good aspect is that in case there is a default from the side of one of the countries, the shortfall can be covered from the contribution of other member nations, who bear the expected liability.
One of the most important and indeed the first issue that has been missed is that the bond protection had a maturity date expiring at 2013. The second issue is the default of the nation and the contribution of the shortfall from another struggling nation. The final issue would be the posting of collateral by the facility so as to support its borrowing an maintain the rating of credits.
5. Given an interest rate of 2.91% for a 10year German bund and the spreads in Exhibit 10 at the end of 2010, what is the range of market implied probabilities of default for Portugal, Greece, Italy, Ireland, and Spain within the next year? What do these implied probabilities tell you about the market’s view of the sovereign debt of these nations?
Given the conditions and the information in the exhibits, it can be stated that the default situation is most prominent in case of Greece. Out of the given countries, Spain seems to be in the most safe and comfortable situation. The probability of default of Greece is the highest whereas lowest is that of Spain. The market view can thus be expressed that when a nation is near a debt crisis position, their chances of getting additional debt is almost nil. When the debt position seems to be somewhat secure, they have easier access and better chances of getting additional required debts.
Calculation and analysis of the default probabilities of these nations can be carried out to assess their future default potentials. The calculated values for each of the country is calculated as per Exhibit 10 to be 0.23, 0.8, 0.3, 0.3, 0.08 respectively for Portugal, Greece, Italy, Ireland, and Spain. The calculation is made according to the formula in exhibit 8 and the data from exhibit 10. This data covers the period of just one year. So, the range of probabilities will be from 0.08 to o.3 inclusive. These data indicate that Spain has the least default probabilities so that it is less risky to invest there. The premium of CDS will be less there because of smaller probability of default while Italy and Ireland are one among the highest defaulter probability. The CDS premium or interest rate will be larger there. In addition to this, the country with higher default probability also indicates that there is some kind of problem in the economy of those countries.
6. How sustainable is the euro zone going forward? Will the system be able to find a solution to the sovereign debt crisis? Should the EU have let overleveraged country members’ default?
In the current situation, there is high risk involved in the sustainability of total Euro zone. This was a clear result of how countries like Greece could not have a measure that should be in line as per the treaties that had been set as a foundation of Euro zone development (Athens, 2016). This may also include inclusion of high levels of spending from the Government and setting of high debt levels. There should be a way out to the debt crisis problems evolving in the Euro zone, given that there is a rather strict check on the operations followed by the member nations. This compliance is critical to the success of the Euro zone sustainability.
References
Athens, V. (2016). Eurozone Raises Specter of Default as Pressure Mounts in Greek Bailout Talks. WSJ. Retrieved 23 April 2016, from http://www.wsj.com/articles/merkel-calls-for-return-to-negotiating-table-in-greek-bailout-talks-1434105544
Elliott, L. (2015). Greece’s problems are the result of the eurozone having no fiscal policy. the Guardian. Retrieved 23 April 2016, from http://www.theguardian.com/business/2015/feb/01/greece-problems-eurozone-fiscal-policy-germany
