By Dada Adefolami
Global financial stability report developed and published by the International Monetary Fund is issued twice per year and provides updates on current economic conditions and financial markets worldwide. Topics covered may include systemic risk assessments, debt management, emerging markets, and current crises that impact the global financial picture.
Monetary Policy
The regulation of the money supply and interest rates by a central bank, such as the Federal Reserve Board in the U.S. and Central Bank of Nigeria , is in order to control inflation and stabilize currency. Monetary policy is one the two ways the government can impact the economy. By impacting the effective cost of money, the Federal Reserve can affect the amount of money that is spent by consumers and business.
Command economy.
This is an economy where supply and price are regulated by the government rather than market forces. Government planners decide which goods and services are produced and how they are distributed.
Fiscal policy
Decisions by the President and Congress, usually relating to taxation and government spending, with the goals of full employment, price stability, and economic growth. By changing tax laws, the government can effectively modify the amount of disposable income available to its taxpayers. For example, if taxes were to increase, consumers would have less disposable income and in turn would have less money to spend on goods and services. This difference in disposable income would go to the government instead of going to consumers, who would pass the money onto companies.
Or, the government could choose to increase government spending by directly purchasing goods and services from private companies. This would increase the flow of money through the economy and would eventually increase the disposable income available to consumers. Unfortunately, this process takes time, as the money needs to wind its way through the economy, creating a significant lag between the implementation of fiscal policy and its effect on the economy.
The global credit market has dramatically underlined the importance of debt finance for both individuals and companies, thus, it is important to understand how the debt market works, and how to cost debt capital.
Equity, capital asset pricing theory teaches us that a firm’s exposure to market risk is the principal determinant of a firm’s equity cost of capital. With debt, market risk is not so important – what is important is whether a borrower will default on a loan. This is called ‘credit risk’.
Default occurs when the value of a borrower’s assets falls below the value of their outstanding debt. Therefore, two variables influence the potential loss to the lender: the chance of default occurring, and the part of the debt that can then be recovered by the sale of the firm’s assets.
If the probability of a company defaulting is 5%, and only 80% of the debt can be recovered by the lender that is, 20% will be lost, then at least an extra 1% (20% x 5%) will be charged to cover the potential loss. It’s not as simple as this in practice because the lender loses not only part of the sum advanced but also the accrued interest.
Lenders, whether in the form of banks or subscribers to bond issues, need to discover the potential loss faced on default and therefore the charge needed to cover exposure to credit risk. Lenders rarely undertake assessments of credit risk directly but normally employ the services of credit assessment professional. For loans to the retail market, there are many credit agencies to which a lender can go. For bigger corporate loans, a lender may undertake the assessment itself or engage a credit rating agency to do it on its behalf. For the largest loans, or where the borrower is considering a bond issue, then the firm concerned will need to obtain a credit risk assessment from a rating agency.
APPROACHES TO CREDIT RISK ASSESSMENT
There are two methodologies for undertaking credit risk assessment. The first involves collecting financial and other measures and combining them into a multivariate scoring system. The earliest work on assessing bankruptcy risk was undertaken by William Beaver in 1966, who identified which of the common accounting ratios had the highest predictive value in assessing bankruptcy risk. He showed that one ratio – operating cash flow over total outstanding debt – successfully predicted default within five years with better than 70% accuracy. Edward Altman in the US, and Richard Taffler in the UK, developed more sophisticated multivariate models. Other models, such as that developed by Robert Kaplan and Gabriel Urwitz, focus on explaining the credit ratings given by the agencies. However, a common criticism of all these models is that they have weak theoretical support; they represent a form of brutal empiricism where data is dredged until measures emerge which best explain the phenomenon of interest.
Over the decades, rating agencies have become more sophisticated in the methods they employ. They have also benefited from the theoretical developments that have led to the second of the two approaches to credit risk assessment. This approach is based on what are called ‘structural models’. Structural models rely on an assessment of the underlying riskiness of a firm’s assets or its cash generation, and the likelihood the firm will not be able to pay interest or repay capital on the due date.
Without the security of counterparty and credit risk assessments, you might enter into trade agreements with financially unstable parties. Should transactions fail, you could find yourself bound by terms of agreement to such parties. Counterparty risks include companies that fail to comply with bonds, insurance policies, or other contracts.
Due to the nature of credit risks, it is often difficult to reclaim collateral from your counterparties, leaving you exposed to financial losses. In addition to operational damages, there are a number of other risks associated with unreliable counterparties.
Credit risk is the damage to your own credit rating as a result of uncooperative, inefficient, or inadequate counterparties. This kind of damage is lasting and can complicate future transactions when potential counterparties carry out their own counterparty and credit risk assessments on your company.
A legal risk can exist if your transaction fails, if you are liable to another party for losses incurred as a result of being able to fulfill transactions, or if you fail to properly protect assets owned by counterparty. Liability and subsequent litigation can incur expensive costs, especially for global companies.
Reputational risk covers losses associated with damage to your company’s reputation. Corporate trust is crucial to securing trade partnerships; with increasing digitization of performance records and communication, damage of this kind is accessible and lasting. Reputational risks include lost revenue, capital, regulatory costs, and damage to shareholder value as a direct result of improper counterparty conduct.
Counterparty and credit risk assessments offer the expert analysis and business intelligence you need to properly assess potential partners. Review your counterparty’s credit history and market performance. Understand their management structure and accountability. Investigate their financial references and payment processes.
INTEREST RATE DERIVATIVES
The interest rate derivatives to be discussed are:
1. Interest rate futures
2. Interest rate options
3. Interest rate caps, floors and collars
4. Interest rate swaps
INTEREST RATE FUTURES
Futures contracts are of fixed sizes and for given durations. They give their owners the right to earn interest at a given rate, or the obligation to pay interest at a given rate.
Selling a future creates the obligation to borrow money and the obligation to pay interest.
Buying a future creates the obligation to deposit money and the right to receive interest.
Interest rate futures can be bought and sold on exchanges such as Intercontinental Exchange (ICE) .
The price of futures contracts depends on the prevailing rate of interest and it is crucial to understand that as interest rates rise, the market price of futures contracts falls.
Think about that and it will make sense: say that a particular futures contract allows borrowers and lenders to pay or receive interest at 5%, which is the current market rate of interest available. Imagine that the market rate of interest rises to 6%. The 5% futures contract has become less attractive to buy because depositors can earn 6% at the market rate but only 5% under the futures contract. The price of the futures contract must fall.
Similarly, borrowers will now have to pay 6% but if they sell the future contract they have to pay at only 5%, so the market will have many sellers and this reduces the selling price until a buyer-seller equilibrium price is reached.
1. A rise in interest rates reduces futures prices.
2. A fall in interest rates increases futures prices.
In practice, futures price movements do not move perfectly with interest rates so there are some imperfections in the mechanism. This is known as basis risk.
The approach used with futures to hedge interest rates depends on two parallel transactions:
1. Borrow/deposit at the market rates
2. Buy and sell futures in such a way that any gain that the profit or loss on the futures deals compensates for the loss or gain on the interest payments.
Borrowing or depositing can therefore be protected as follows:
Depositing and earning interest:
The depositor fears that interest rates will fall as this will reduce income.
If interest rates fall, futures prices will raise so buy futures contracts now at the relatively low price and sell later at the higher price. The gain on futures can be used to offset the lower interest earned.
if interest rates rise the deposit will earn more, but a loss will be made on the futures contracts bought at a relatively high price then sold at a lower price.
With FRAs, the objective is not to produce the best possible outcome, but to produce an outcome where the interest earned plus the profit or loss on the futures deals is stable.
Borrowing and paying interest:
The borrower fears that interest rates will rise as this will increase expense.
If interest rates rise, futures prices will fall so sell futures contracts now at the relatively high price and buy later at the lower price. The gain on futures can be used to offset the lower interest earned.
Some people confuse by how you can sell something before you have bought it. Simply remember that you don’t have to deliver the contract when you sell it: it is a contract to be fulfilled in the future and it can be completed by buying in the future.
Of course, if interest rates fall the loan will cost less, but a loss will be made on the futures contracts sold at a relatively low price then bought at a higher price.
Once again, the aim is stability of the combined cash flows.
In summary:
The summary rule for interest rate futures is:
1. Depositing: buy futures then sell
2. Borrowing: sell futures then buy
Freely floating system where exchange rates are determined entirely by the markets. Governments may attempt to increase or decrease the value of a currency by using monetary and fiscal policies, but in this system, they do not directly interfere with the value of a currency. For example, the value of the US dollar is driven entirely by market factors such as supply and demand, though the Federal Reserve controls the money supply and can increase or decrease their spending.
The credit market is a broad market for companies looking to raise funds through debt issuance. The credit market encompasses investment-grade bonds and junk bonds, as well as short-term commercial paper.
The debt market is the market where debt instruments are traded. Debt instruments are assets that require a fixed payment to the holder, usually with interest. Examples of debt instruments include bonds (government or corporate) and mortgages.
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