Normally we refer to “risk premium” as the different in the interest paid
by a risky asset versus the interest paid by a risk-free asset; then when
we talk about the risk premium of a specific country, we are normally
referring to the additional interest paid by the debt of a government of
that country, in comparison to the interest paid by the government debt of
a “benchmark country” with a reputation for having a very reliable
financial strength and therefore, for which the possibility of default is
minimum or nonexistent. More specifically, Greece debt would be the “risky
asset”, German bonds are seen as the risk-free benchmark in the Eurozone,
and the difference in return between them is the risk premium paid by
Greece, this is as simple as it gets.
Now, what does the risk premium of a country says when such a country is
likely to be facing a default scenario, and by default I refer to any form
of “voluntary” or non-voluntary change in the terms of the outstanding
debt, such as a haircut in the capital or an extension in the terms of
payment, either way producing a change in the cash-flow of mentioned debt.
Let’s start by how the yield of a bond is calculated, and basically we will
find out the yield of any bond by comparing its cash-flow to its current
price, the rate that produces a present value, for a given cash-flow, equal
to its market value would be the yield of such a bond. And this will be
always correct, unless the market is already expecting some kind of
default, voluntary or compulsory debt restructuring, which will produce a
change in the cash-flow. In such a scenario, the market value of a bond
would be the present value of the new cash-flow expected by the market, and
since this expected cash-flow would be smaller in value and/or longer in
time, the expected yield when someone buys a bond that is expected to enter
in default, is necessary lower than the yield calculated based in the
original cash-flow of the bond; consequently the risk premium of a country
facing default is overestimated.
But what is the relevance of all this, and most importantly, what is the
use of it. Well, there are some important applications and conclusions
based on this concept.
First of all, we can take a look at the yield of the debt of countries that
actually defaulted, prior to their default, and see what was the
risk-premium they had. If we compare that risk-premium with current
Greece’s risk-premium, we could have a good indication of whether the
market is already expecting some sort of default. Secondly, we can see what
the historic risk-premium post default was, and that would also be a good
indication of what would happen with Greece’s risk-premium after a default,
then we can use this new risk-premium to have an indication of the new
yield of its debt post default, and since we know the current market value
of Greece’s debt, we can predict possible cash-flows that would be
consistent with current prices, and therefore to have an idea of what kind
of haircut or extension the market is expecting.
Today we have two strong antagonistic positions, on one side people sustain
that any kind of default has to be avoided and therefore, they are willing
to dedicate large amounts of resources into rescue packages for Greece in
order to avoid its default; on the other side we have people that sustain
that a default is unavoidable and therefore, to keep dedicating resources
into rescue packages for Greece is a waste of time and money and it’s not
helping to solve Greece problems.
If the market is already expecting some sort of default, the longer we
postpone it, the more expensive will be for Greece’s government to raise
fresh funds, since they would be raised at a yield that indicates that
current situation is not sustainable and a default is expected, rather than
to a lower yield in a post default scenario. In this case, the best course
of action is to put together a debt restructuring plan in such a way that
would be consistent with market expectations and Greece financial
situation; this would eliminate the uncertainty in the market and therefore
it will allow Greece to start improving its economic situation instead of
extending the current scenario of struggle and political unrest that we
have been seen for quite some time.
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