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Risk Permia in the Sovereign Loan Market

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  • Jeannine M. Farazli

Abstract

This paper offers an explanation of how risk premia emerge in the sovereign loan market. The economy is composed of countries which borrow each period from private banks. In the event of default, the bank imposes a penalty by seizing the country's overseas assets. The country may also choose to appeal to an international authority, such as the IMF, which determines whether the country must repay the loan or pay the penalty. This process takes one period to be completed and its outcome is stochastic. In an environment with a deterministic penalty to default, the supply of funds schedule is upward sloping. The interest rate on sovereign loans is greater than the prime rate charged on private loans, implying the existence of risk premia.

Suggested Citation

  • Jeannine M. Farazli, 1992. "Risk Permia in the Sovereign Loan Market," Working Paper 850, Economics Department, Queen's University.
    • Handle: RePEc:qed:wpaper:850
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    File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_850.pdf
    File Function: First version 1992
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