Question

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

Short answer

Greek debt is riskier to invest in because Greek bonds are riskier, so investors demand a higher interest rate to compensate for the additional risk.

Step-by-step solution

Definition

Bonds: A bond is an instrument of obligation issued by the bond issuer to the bondholders. City securities and corporate securities are two of the most well-known types of securities. Securities can be in the form of common assets or private contributions where an individual gives a credit to an organization or a public authority.

Explanation

The Greek government's poor financial standing reduced demand for its bonds, as shown in the graph below:

Interest in Greek bonds will fall from B_D to B_D' as financial experts lose faith in the Greek government's ability to repay its obligations due to its high spending emergency. The price of Greek bonds then falls from P_G to P_G'.

Meanwhile, the fall in demand for Greek bonds increases demand for US bonds, as shown below:

Demand for US bonds increased from B_Dto B_D' as investors sought alternative investment options as Greek bonds became riskier. As a result, the price of US bonds rises from P_US to P_US'.

The risk premium between US Treasury debt and comparable maturity Greek debt exists because Greek bonds are more risky to invest in, so investors demand a higher rate of interest to compensate for the additional risk they are taking on. Bond prices and interest rates are inversely connected, so keep that in mind. The fall in the price of Greek bonds indicates an increase in the country's interest rate.