Potential Impact of a Eurozone Break-up on Foreign Exchange Swaps and Currency Options Contracts

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A principal use of options and swaps is to hedge currency risk. The adoption of the euro as a common currency for a group of European countries in the eurozone (and before then to a limited extent through the European Currency Unit and the associated exchange rate mechanism) had a profound impact on currency risk, as it eliminated currency exchange risk within the eurozone.

Correspondingly, a break-up of the eurozone would have important implications for euro-denominated derivatives arrangements, perhaps calling into question whether existing transactions denominated in euro provide viable hedges for obligations that have been redenominated into new currencies. Questions may arise regarding the impact of a redenomination on the performance obligations of parties to transactions and ultimately the pricing of such transactions. The risk of redenomination of FX transactions payable in or involving delivery of euro highlights the necessity in analyzing contracts that contain euro obligations.

This alert will consider the impact that the withdrawal of one or more countries from the eurozone may have on currency swaps and options that involve the payment or delivery of euro, whether by a non-eurozone swap participant or by a counterparty seeking to hedge risks specific to a country that has ceased to use the euro. It will first outline the scenarios in which a eurozone break-up may occur, then will outline the basic documentation for foreign exchange transactions and finally will analyze how a eurozone break-up under the specified scenarios may intersect with the transaction documentation in perhaps surprising ways. The focus of this article is on how a currency redenomination may affect currency derivatives transactions rather than the circumstances in which a redenomination could occur.

Please see full alert below for more information.

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