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Three Types of Risk: Default, Interest Rate, Country


Picking up a discussion we had been engaging in of late about the types of risk faced (and, one must hope, managed) by financial institutions....
 
Default risk is the risk that some counterparty with which the risk manager’s own concern is doing business, and from whom they are receiving contracted-for payments, will stop making those payments. They might stop payment either with malice aforethought (as with crooks who take your valuables, promise you a series of payments, and then skip town), or they may stop payment due to some financial crisis that leaves them incapable of doing so. In other words, your own liquidity risk as defined above is somebody else’s default risk.

Interest-rate risk is the risk that a change in interest rates will undermine the value of an entity’s assets. For example: on any given day there is some risk that a central bank’s decision to increase interest rates will hurt the value of stocks (because it makes lending money relatively more attractive vis-à-vis owning equity). So the interest-rate risk for those who own a lot of entity is an interest rate increase, while the interest-rate risk for those who own bonds or otherwise lend money is the opposite, an interest rate decrease. This point makes the case for diversification: a portfolio should include both stocks and bonds.

We should also mention country risk in this connection. This is default risk as it applies to sovereigns and the bearers of country risk are the bearers of the bonds issued by the sovereigns who may default.

There are dramatic differences between plain-vanilla default risk and country risk. One quite obvious one is that there is no bankruptcy procedure for countries. If a private entity that owes money to our widget manufacturer stops paying its debts, it may either voluntarily seek the protection of the bankruptcy courts or it may be forced into bankruptcy proceedings by the unhappy creditors. Either way, the point of the bankruptcy proceeding is to produce an orderly rescheduling of payments from out of the assets of the estate, at the expense first of the owners of equity and later of the more junior or subordinated debt holders. There is a good deal of uncertainty in corporate bankruptcy proceedings, but there is a familiar procedure taking the creditors down a road and only two possible outcomes, liquidation or reorganization, at the end of that road.

In matters of country risk, nothing is that clear cut. Every threatened default brings its own ad hoc proposals for a restructuring of debt. Every actual default creates a highly speculative market in the defaulted-upon instruments, some often very creative efforts at collection, distinctions between classes of creditors and their mutually opposed claims on the issuer, etc.
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