Interest rates default risk and the risk premium

The main text assumes that creditors can always be sure that interest payments will be made and loans will be paid off at maturity. So we are talking about bonds with no default risk. In such a situation all that financial investors need to do when investing in international bonds is compare interest rates (assuming they do not expect the exchange rate to change).

While this is probably a reasonable first assumption when talking about government bonds in many industrial countries, governments do occasionally default on international loans or interest payments. In the presence of such default risk the equilibrium condition for the international capital market changes and thus needs to be reconsidered.

Assume there is no default risk at home. Then one euro invested at home grows to

Euro

and expanding terms this yields

If we ignore the final four terms on the right-hand side, which are small under normal circumstances and partly offset each other, this simplifies to

after one period. A euro invested in Russia, where default risk is DR, can be expected to grow to

So even if the exchange rate is not expected to change, default risk may drive a wedge between domestic and foreign interest rates. Investors require a higher interest rate (or, more generally, a higher expected return) on Russian assets; a risk premium RP, which is equal to the default risk in our case. Generally, when expected depreciation is zero, the risk premium on international investments, RPWorld, drives a wedge between domestic

(2) and foreign interest rates:

since we need to take into account expected changes in the exchange rate and the possibility of default. Investors are indifferent between investing in Euroland or Russia if these two expressions are the same. Setting (1) equal to (2)

While we only looked at default risk here, many other things may give rise to a risk premium in financial markets, such as expropriation risk or risk aversion.

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