Publication

Abstract : All else being equal, debt obligations in foreign and local currency carry different default risk. This is commonly recognised in the case of sovereign debt, but less so for non sovereign, i.e., private sector, obligors. To the same obligor, the incremental default risk on a foreign currency obligation is due to transfer risk, a fact which is explicitly recognised in the Basel framework. In the more general case of two different obligors who may otherwise be the same, the foreign currency obligation bears, in addition to transfer risk, various other elements of country risk. From a review of the consultative documents and the legislation, we surmise that the likely intent within the Basel framework is that the incremental default risk due to at least the transfer risk element should be captured within a bank’s rating system and capitalised under Pillar 1. We derive formulas for adjusting the default probability of an obligor to take account of transfer risk, which is one approach by which this might be achieved.