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Dynamic Economic Decision Making: Strategies for Financial Risk, Capital Markets, and Monetary Policy by JOHN E. SILVIA

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Chapter 6

Risk Modeling and Assessment

In June 1863, the Confederate States of America issued the Seven Percent Cotton Loan. The principal amount was not paid in Confederate dollars or payable at the Confederate capital of Richmond. Instead, the payments were set in sterling or French francs, in 40 installments to be paid in Paris, London, Amsterdam, or Frankfurt at the option of the bondholder. In addition, payment could be received in cotton, instead of currency, at the option of the bondholder at any time not later than six months after the ratification of a treaty of peace after the war.1

This bond structure reflects a keen sense by the issuer of the risks for the investor. The risk of devaluation was covered by payment in sterling or francs. The payment in cotton was a hedge against inflation. The option to convert at any time was a hedge against the fortunes of war and sovereign and political risk.

In this case the elements of risk can be seen, especially the information asymmetry about the state of the war. Clearly, European investors could not monitor how the war was going as well as the bond issuer, the Confederacy, could. In addition, the changing fortunes of the war over the period of the bond's lifetime suggest the dynamic character of risk and the constant need for updating of the decision framework and monitoring by the bond investor. In June 1863, the Confederate army at Vicksburg was still holding out against General Grant and General Robert E. Lee had just entered ...

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