Sovereign risk is a risk associated with financial agreements which involve national governments. While working with a government is generally believed to be low risk, governments can fail to meet debt obligations, change the terms of agreements, alter foreign exchange rates, or engage in other activities which can endanger investors. Before dealing with a national government, sovereign risk is one of the things which must be considered.
People and entities which loan money to national governments are vulnerable to sovereign risk. This has historically been a big problem with some nations, which borrow money and are then unable to pay it back. While payment agreements can sometimes be worked out or international agencies can assist with repayment, creditors can still take a loss or the repayment can be delayed. Creditors may also be expected to work with financially struggling countries by forgiving debt or being amenable to changes in loan agreements.
One aspect of sovereign risk is that debts simply may not be repaid, or will be subjected to write downs in value so that the government does not need to pay the debt in full. People can also be at risk when the law limits people doing business in a country and makes it challenging for them to repay debts of their own. Furthermore, sovereign risk also includes the danger that a country will make changes to laws, treaties, and other agreements which result in problems with loan repayment.
People who hold foreign exchange (forex) contracts are also in danger. In their case, a change to regulations or the exchange rate can result in a precipitous decline in value for the contract. People may lose money as result, either because they are forced to sell at a lowered price or because they cannot cash out on the contract until the market stabilizes, and they may be left holding it for an extended period of time while a country works to control its currency.
Just like companies, nations can be rated in terms of creditworthiness. Independent assessments of sovereign risk may be performed before a deal is signed, to ensure that the deal is appropriate. Ratings are also published in some investment publications for the benefit of people working with foreign exchange contracts or considering the purchase of foreign bonds. As with any type of deal, the more information an investor has at the start, the more smoothly the deal can be put in place.