Legal Risk Premia During the Euro-Crisis: The Role of Credit and Redenomination Risk
Discussion Papers on Business and Economics, University of Southern Denmark, 10/2015
83 Pages Posted: 21 May 2015 Last revised: 4 Jan 2016
Date Written: June 25, 2015
Using several new datasets, I document the role of legal risk premia in bond yields during the Euro-crisis. I find evidence of a rising premium especially in late 2011 and mid-2012 on bonds with foreign governing law relative to those with local governing law (and otherwise similar characteristics). The results illustrate that legal risk premia spiked at the height of the crisis in the Eurozone, when investors were willing to pay a premium for the additional protection offered by foreign law bonds. I show that this governing law premium can be linked to both credit risk (expected haircuts) and redenomination risk (expected currency depreciation). This paper is the first to empirically link the governing law premium to redenomination risk. I find evidence that redenomination risk is an independent driving force of governing law spreads over and above credit risk, although it is analytically challenging to separate the two risk factors. My findings, while not fully conclusive, are consistent with the consensus in the literature on contract law, which argues that local law financial instruments should be more susceptible to redenomination in a scenario of a country exiting the Eurozone.
Keywords: General financial markets, International finance, Foreign exchange, Contract law, Financial econometrics, Financial crisis
JEL Classification: G1, F3, F31, K2, C58, G01
Suggested Citation: Suggested Citation