DEFAULT RISK AND INTEREST RATE UNCERTAINTY IN INTERNATIONAL FINANCIAL MARKETS

This study utilizes a two-period model of international borrowing and lending to spell out a detailed theory of rationing in the presence of sovereign default risk. Under complete certainty, the credit ceiling is a downward-sloping function of the interest rate in international loan markets. Borrowers that face rationing will be forced to undertake sub-optimal domestic austerity programs in order to increase domestically financed investment beyond its intertemporal optimum level. Such borrowers will suffer from a permanently lower level of income and consumption. Interest rate elasticities of credit demand and credit supply become critical factors in determining the interest sensitivity of domestically financed investment. Rationed borrowers will not be able to finance a temporary adverse shock and with a permanent adverse shock, foreign borrowing falls and domestically financed investment increases. The study is extended to incorporate the existence of variable interest rate loans in international financial markets. The credit supply becomes a backward-bending function of the risk premium charged. Borrowers with past history of investments are rewarded with larger credit ceilings and/or pay lower risk premiums. A number of equilibrium comparative-statics results are derived both for risk averse and risk neutral borrowers including an increase in expected value and volatility of interest rate. An increase in credit supply will lead to less rationing but no change in the risk premium. Expected utility of rationed borrowers will increase as penalties for default increase but also may lower the expected utility of some unrationed borrowers. The frequency of default may increase as penalties for default increase. The model is also used to examine the issue of sovereign over-borrowing . Finally, the determination of interest rates in international financial markets is examined. The hypothesis that the current account balances of OPEC and Non-oil developing countries have significantly different effects on the Euro-dollar rate is supported by empirical evidence. Overreaction of the Euro-dollar rate to any changes in U.S. interest rates is attributed to the possibility that Euro-dollar rate is a percentage mark-up over the U.S. Treasury bill rate. Almost all of the adjustment in the Euro-dollar rate in response to any change in U.S. Treasury bill market takes place within a quarter. (Abstract shortened with permission of author.