Globalization, Gating, and Risk Finance

8Credit Risk and International Debt

Motivation

Credit and capital flows, together with trade (Chapter 9), underlie the expansion of financial globalization by providing liquidity and the capital required for economic development. Banks, financial markets, insurance firms, and a multitude of other financial institutions increasingly use innovative products that have contributed to the expansion of global credit and finance. This chapter provides an overview of credit risk and debt pricing. We introduce multi-country credit risk and its models from a number of perspectives. Technically, we define credit from three points of view: (1) a personal utility‐based approach to credit prices and bipartite lender–borrower exchanges, (2) fundamental finance, option‐based, and structured approaches to securitized risks based on Merton’s model, synthetic instruments, and securitized credit and insurance products (e.g., credit default swaps (CDSs)), and (3) central bank’s policy regarding interest rates and liquidity. Lenders and banks are intermediaries for central banks. They manage liquidity through interest rates and monetary policy (e.g., QE). Thus, globalization and credit growth are mutually dependent, and causally contribute to the expansion of global finance.

8.1 Introduction

A credit between two parties is a trust that one bestows on the other to meet previously negotiated commitments. For example, a lender trusting that a borrower will meet a contractual commitment. In a foreign ...