Critically Analyse How the Government Debt Problems Initially Faced by a Few Relatively Small Economies Could Trigger Such a Wide Impact in Financial Markets

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Critically analyse how the government debt problems initially faced by a few relatively small economies could trigger such a wide impact in financial markets

Since the Greece's debt crisis happened, the Euro zone has to confront with a huge sovereign debt crisis, like governments' debt increased, bond yield spreads widened, Euro exchange rate fell as well, which caused that the whole international financial markets gradually lost the confidence. The purpose of this essay is to discuss the impact of this crisis both on foreign exchange and derivative markets. And the rest words is to analyse several possible reasons why this small economy could trigger such a wide impact on global financial markets, in which contagion can
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As a result,most of potential buyers and sellers of bonds in the sovereign debt market began to suspect the governments’ ability to repay its debt, and then they will require a higher bond discount rate in the potential risk of default about sovereign bond as the part of the compensation of risk premium. When the discount rate significantly exceeds the risk-free rate, the national debt will be in a rather high discount rate. In addition, the CDS price of the European countries increased rapidly. As we saw from the graph6, the Greece five years CDS price had reached to almost 1500, which reflects the buyer of the CDS have to cost a relatively higher fix rate to buy the Greece’s credit risk call option.

Graph 6 5 years’ Sovereign CDS risk premium and Sovereign credit rating in different countries.
Source: Bloomberg

Another impact on derivation market is the Futures and Options. Traders and hedge funds had bet nearly $8bn (£5.1bn) to against the euro, amassing the biggest ever short position in the single currency on fears of a euro-zone debt crisis. Figures from CME(Chicago Mercantile Exchange) illustrates that investors had enhanced their positions against the euro to record levels. This phenomena demonstrates that investors were losing confidence in the single currency's ability to withstand any contagion from