Question

In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis.  Using appropriate bond market graphs, explainthe effects on the risk premium between U.S. Treasury debt and comparable maturity Greek government debt

Answer 1

In each graph, bond price (P) and quantity of bonds (Q) are depicted vertically and horizontally respectively. D0 and S0 are initial demand and supply curves for bonds, intersecting at point A with initial bond price P0 and quantity of bonds Q0.

(1) Greek Government debt market

Increase in default risk of Greek sovereign debt will make investors shy away from buying Greek government debt. This will decrease the demand for Greek government bonds, shifting its demand curve leftward. Price and quantity of Greek government bonds will decrease. Since bond price and yield are inversely related, lower price will increase yield of these bonds.

In following graph, D0 shifts left to D1, intersecting S0 at point B with lower price P1 and lower quantity Q1.

(2) US Treasury debt market

Increase in default risk of Greek sovereign debt will make US Treasury debt safer, and investors will find US Treasury debt more attractive. This will increase the demand for US Treasury bonds, shifting its demand curve rightward. Price and quantity of US Treasury bonds will increase. Since bond price and yield are inversely related, higher price will decrease yield of these bonds.

In following graph, D0 shifts right to D1, intersecting S0 at point B with higher price P1 and higher quantity Q1.