Default risk is the probability that a company or an individual will not be able to pay their debts obligations. Thus any time that an investor or a lender gives out a loan to a person or a company who might not be able to repay it they expose themselves to default risk.
Among other default risk solutions, a creditor can set a default premium which can be used to cover the default risk. The default premium is the additional amount that any lender sets for the borrower to pay indirectly while repaying their loan. This amount is determined by subtracting the rate of return of a risk-free bond from the rate of return of the corporate bond you are purchasing. The Merton Model, Edward Altman’s Z-score and the Jarrow-Turnbull financial models are used to analyze default risk.
Sovereign risk is the type of default risk associated with the government not being able to meet loan obligations. Before a creditor deciding to lend any foreign country, the lender must consider the risk quality of the country and the credit quality of the firm. A perfect example of this type of default risk happened in 2015 when Greece failed to make payments to an IMF loan. Another example is when Argentina defaulted on a World Bank debt which was worth one billion dollars during the country’s economic crises in 2002. Due to the 1998 Russia finance crisis, the country defaulted on internal bonds but not its Eurobonds. When sovereign countries such as the above nations default on their loans, they are not liable to court suits or bankruptcy courts.
A strategic default is an intended default of a loan. This happens when a borrower can pay a loan, but they choose not to. This is mostly applied to nonrecourse loans whereby the debtor cannot get any other claims from the creditor. A good example of this is when mortgage loans have negative equity in countries where the common law is applied like America. In this case, the debtor halts making the loan payments and just sends the keys to the lender which is usually a bank.
A sovereign country can also opt for a strategic default type of loan. However, in this case, it will be called a sovereign strategic default. A good example of this happened in Ecuador in 2008. This was when the Rafael Correa who was the president of the country at that time decided not to make payment for his country’s debt. The president then stated that the cause of the default was that he thought the debt was illegitimate and immoral.
A consumer default arises when an individual doesn’t make the payments required for payments such as utility payments, mortgage payments or rent, and consumer credit among others. A good example of this happens when an individual suddenly fails to make payments d due to losing a source of income, when income decreases, unemployment or even personal issues that may arise at any time. However, research shows that being young, illiteracy, or even being too old maybe also contribute to defaulting consumer loans. Regardless of this, this type default often attracts legal litigation cases or even bankruptcy procedures.