FUN~ ~ rAl Sor- I INM1r: 1111 t,,,.

- - - - --- -...- - - - - - - · - - - - - -....... ••. ' 11,:,

Credit Risk and Interest Rates

Credit nsk is one type of business nsk. Thia is the ris't that ·the ~.>c.>rrowr.,r vr
able to ,repay ,ts obl1gat1on. Such risk is valuated as a factor to determine th(j ;.,~ ,
lending or financing using debt. Credit risk also affects the .:v- aluat,or1 of ar.,x~f.J· •n"J
receivable. , ~ , · "'~
"' t ...~ I,•

1
; J I

Theories related in Setting Interest Rates

According to Fabozzi and Drake, there are two economic theories that drive; th
interest rates. These are loanable funds-theory and liquidity pr~ference theo~. Loana~
funds theory assumes that it is ideal to supply funds when the interests are high alid 'if"
versa. This theory was introduced by Knut Wicksell in 1900s. 1:6

On the other hand, liquidity preference theory was introduced by John Mayna,q
Keynes, that the interest rates are dependent on the preference of the household Wh!i!th~r
they hold or use it for investment. There by that the longer the term the higher the rate~
because investors pr_eferred the short-term investment more.

BSP defined interest rates to be a type of price. Interest are set to compensat: the
risk of allowing the finances to flow into the financial system. The interest as a pnce 15
different on the perspective of the lender or borrower. F.or tenders, interest rate i2. .call~,:,
as ~nding rate or return. For the borrowers, these will serve as cost of debt. Interest rates
were classified depending on the type of instrument they derived and the tenor of the
investment.
The ~ or of the investment also defines the riskiness of the repayment of debt
The longer the life of the debt the riskier the repayment hence the interest rate is higher
There are tvvo economic theories that affect the term structure of interest rate. These are
expectations theory and market segmentation theory .

• Expectation Theories

Expectation theories is that the interest rates are driven by the

expectation of the lender or borrowers in the risks of the market in the future.
These maybe a pure expectation theory and biased expectation theory. Both
theories understand how interest rate, or the temi should be structured over
time.

Pure expectations theory is based on the current data and statistical

analysis to project the behavior of the market in the futu-re. They all rely on the
forward rates or the future interest rates based on their projection on the future
prices. Of course, expectation on the interest rates varies depending on the
perspective and the maturity. For example, Company A needs to finance a
project that will be operated in perpetuity. Company A applied for a loan to
Company B payable for 20 years. The prevailing interest rate at present is 7%.

126 I
 Based on the current .
How will. . environme t h9
the interest rate be n · ,t market seems to worsen in the fut~re .
Company B must assum ha_ve in the future? With the given information,
Company A may pay in
be based on the stron
th:fit h,g~er rate than 7% since the probability that
. ure 15 becoming low. The pure expectations shall
r~tes to be agreed sho~l:~t~mates based on the uncertainty of the futu ~e. The
will not be fully comp reasonable enough for both parties otherwise one
ensated 0 .
that the pure expectations specially on_ the part of the lenders. Observed
factors. th eory only relies on the term and not on other

Biased Expectaf
affect tile term str t ion Theory includes that there are other factors that
moving forward. T~~ ~~e of th e loans .as well as the interest to be perc~ived
liqu idity of the bo rwa rd rates w,11 be affected or will be adjusted 1f the
or increase on ~~oew~r will be weak_ er or stronger in the future. The adju_s~e_nt
prem ium incr interest rate 1s called the liquidity premium. L1qu1d1ty
theory A t~ases as th0 maturity lengthens. This theory is called the liquidity
habitat
.
t;o th
er ~ory under the Biased Expectation Theory is the preferr_ed
eory. This theory does not only consider the liquidity but the risk
premium as well but disregarding the consensus of the market on the future
intere st rates. The habitat being referred here is the biased estimate over the
market beha vior in the future

• Market Segmentation Theory

This theory assumes that the driver of the interest rates are the savings
and investment flows. The maturities are segmented depending on how the
assets and liabilities were managed as well as the lenders on how they extend
fi nancing. It is the same with preferred habitat theory however it does nol
assume that any of the players are willing to shift. sector should opportunity to
ari se for the asset or liabilities to be retired or lenders to offer higher rates.

Determination of Interest Rate

To determine the appropriate Interest rate or rates the following factors

should be considered assumi ng the cash flows are already been established :

• Interest rates 1n the industry

• Risk e"posure
• Cornpens..:1 iwn Q_Qthe market expectation.
fina nce, intere5't can be determined by the function of the risk and the
111
.ostor on the difference between the nsk-free rate and the markel
compensation of th e ,nv<;:
fluctuations (Eq 5. I).
Eq 5.1

I -:: interest . .. )
. k, rate where {Real nsk free rate = Rf - inflation
R, = ns 1ree k .
. bt 1argIn or debt spread or the ris premium
dt~ · 11
Om= 1

121 I
 --- ·- -- -- -- -- -- - ma~ ioro do1au'• r. tt-,, mar. ..tJt "r.1w
n .o rt· It: rt\1 mto &hovld tho rate fha: as$u Hence . n0rlll ilj , "
o t1eu1<J by thg ,;overotgr.
th ru n 010 or lea, equ va unt to the rntoo
o tjy tho ror., ,rhc-;.1n the Ph •t1P Plflet •t i ~
o' ho riSk..frao ,-at.-a the 1 reas ury ollls ssuo ~·
nf:"to bo re1er'fcd 1n tho Ph,ftcpinc Oon 'rng Sys
tems or: POS Groop
The POS Group ,s an..organized r"'au n f:h~
. 1 n.c,.7 Yr.
Pom t of fnfo rma tion r 'OtmM out 0 • the f.na nca~ I ,s PSS lfl
d tr -:1"';) Us r" ,~
4

technology, the grou p provides full financial serv 1

ceo ,..' ..
PDS flfOVkiotJ mtos for The grO\:,
govemm ent sccunttes u:.,ng trad ing to cieanng and to set11eme nt
t~a 1,,.,") ~a:~
thll BVAL •-Ar,-t.hOd. ology for composed of four corporaho~ Phtf ,pp,ne-

I Govemment. Supran.ational. , b cc.hange C,orp (PDE~, thei r trading services

1 A.Qency and Investment-
Grade Corporate Bonds jPhihpp•ne Depository and Trust Corp . (PD
TC) for t-
emer1
i:J ,.:
ec,:
securitJes serv ices , Ph•hpp,ne Securities Sett1
ices , and the PDS Aca dem y for: Mar;:
(PSSC ) for their payments and transfer serv ·
er.
Deve1<,pmeo1 0orp (PO SA) as their training cent
ct of inflation or the e.xcfusion ,,
Tho nsk free rate can be real or excludes the effe
e Peso Since the real nsk free rate exei"'~'=~
the effect of the purchasing power of Phili pp,n
free adJusted for inflation may assu,.,.:. .
the inflation the nominal .vh1ch ,s the nsk
cornpou nd1n~ effec t m the future Since the
BSP is the main supplier of the bank rese;eS:
ot set the infla tion expectations. Hence
it cannot set the rea l ,nterest rates because it cann
determined by dedu ct ng th~
it is morf\ app ropnate to say the real nsk free rate can be
preva1hno inflation
borr ow funds from Oberon Financing
Let's illustrate , Morgana Corp . would like to
is 2%. In the following yea r, the inflatt0r
The nsk free rate is 8% and the current inflatjon
the 4% margin remains to be relevari•
1s expe cted to grow to 3% . Oberon still finds that
ncing shou ld impose to Morgan Corp ?
How much 1s the Interest rate that Oberon Fina
i = (Rr + Dm)
hence we have to reca lculate t:
We know that the risk free rate is nom inal
power in the future . Hen ce, the real risk tree
inco rporate the forecasted risk of purchasing
rate should be reca lculated.
Rrr = (Rr - Inf lat ion)

Rrr = 6% - 2%

Rrr ::::: 4%

The rea l nsk free rate rs 4 %, since the repa

yment will be made in the future,
Obe~on should con side r t~e fore casted infla
tion . Transposing the formula to determine
ate the 3% inflation fore cast:
the nsk free rate nominal ,n the future and incorpor
Rr = (R1r + lnf lation)
Rr = 4% + 3%
R1 : : : 7%
- FUNDAMENTALS OF FIN A.NCIAL MAR ¥E.T

Now the nominal risk free rat .

th e
applicable return that Obero neF~PPlic~ble for the loan is 7% . We can calculate
d •
Inanc,ng nee in orde r to kept them whole by

i;;;:: 7% + 4%
i = 11 %
. .
Ther~for~, th~ inte rest rate that Ob the
question Is will this be acce t ble eron Financing should charge Morg an is 11 !>!,_ Now
· be d.1ffere nt to the borro Pa to Morg ana corporat,on? The assessment then aga1r
will tr' the future
that the inte rest will go wor t~r. Morgana should cons ider if their assessment
1 th
then 11 % is a good offer . Suppose , another
financing compan y is offer" e ; 0 ethlong term a
~na should reconsider. In addition, Morgan
Corporat ion in the long ru~:gh 1/o en Morg ld
~der that the interest cost on their end wou
also result to tax ben efits if ho~ld also cons considered as a tax-deducbb le expense .
' t e interest cost 1s
Another way on how to cal Iat e the .1_ nterest rate is by the function of the market
valu e.
par value and the 1. t cu
t deb t securities or bond s. Eq 5.2 pres ents the
formula suggested ~0edreS ex~ense ~aid by .
etermme the interest rate on debt securities

I+ ( V - M)
Eq 5.2 i = V+~ x 100%
- 2-

i = inter est rate

I = periodic inter est paym ents
V = par value of bonds
M = mar ket value of bon ds
n = term of bonds

s with 10% nominal rate for a Php 1.000 oar

To illustrate , Merlin Corporation issued bond
were sold for Php 1,200. How much is the
value bon d payable for 20 years. The bonds
ket?
interest rate of the Merlin bonds in the mar
of Merlin bond s
Using the formula in Eq 5.2 the interest rate
(l,QQ Q X lOO/o)+ ( 1,000 Z~ 1,200)
i = 1,000 + 1,200 X lQOo/o
2

, - 200 ,
. 100 + ( 2t) "j 0

l = Z,2 QQ X 1001/o
-z
100 - 10
i = - - - x l 00%
1,100

129 ;
 i = 0.0818 X 100% = 8.18%

The interest rate in the market is 8.18% which is lower than the nominal rat
10% for the Merlin Bonds. This means that the same bonds are perceived to be riski: Cf
the market as compared to the nominal rate. But what if the bonds were SOid r 1n
O
_premium? Note tha! the market value of the bond is Php1 ,200 hence there is a pr801 ~~
on the Php1,000 par value of Php200. This is because the bonds ~re guaranteed by Merli
Corporation to earn 10% interest while the market can only provide about 200 bps lowe~
than market.

On the other hand, the bond sold at a discount expects that the nominal rate of the
instrument or bond of the same class is lower than the market. Assume that Meni
Corporation issued Php1 ,000 par value bonds paying Php100 interest every year for ~
2
years where their bonds were sold at Php950. How much is the rate of cost of debt in the
market?

It can be noted that the difference this time is that the interest is given at Php100 and the
bonds market value is Php950 lower than the par value of Php1 ,000, therefore there is a
discount. The same problem can be solve using Eq 5.2

(100) + ( 1,000 - 950)

.- 20 1000¾
l - 1,000 + 950 X D

50
100 + ( )
I , i = 1,950
20 x lOOo/c
°
-r
100 + 2.50
i = l gSQ X 100%
I

i =0.1051 X 100% = 10.51%

This time the interest rate is 10.51 % higher than the nominal rate of 10%. Given that the
difference is about 51 bps, the market value is discounted by about Php50 only (Php1 ,000
- Php950). You may observe that using this formula , interest rates can be determined
depending on how the nominal or guaranteed interest rate fairs with the market or effective
cost of debt.

. In commerce, r!sk is a very important factor to consider that may drives the
business up or down. ~,~k relates to the volatility of return patterns in the business. Thus,
the challenge on quantifying the risk is imperative for the investors to be able to determine

130 I
- FUNDAME NTALS Of FINANCIAL MARKET
hOW much they can keep th
. 9 tra t· ernselves wh I
?
financin h nsac ion • Thesa are defa It e. There are risks that are inherent in every
among ot ers. · u nsk, liquidity risk , legal risks, and market nsks,

. Default risk arise on the inabi . ! '<

businesses was able to raise f _lity to make payment consistently. Most of the
projected were not that g inancing on their demands, however their cash flows
. . uaranteed B · 11
princ1p1e 1s to allow the b . · as1ca Y, the cash flows management
company is made aware of ~Sl~ess . to . self-liquidate or self-finance . While, the
they may fail to make sure th et
penod,c obligation but there are still chances that
th
paying the amortization incl ~- ~ funds wer~ available upon servicing of _debt or
determining the probabil"t u mg interest. This type of risk may be quantified by
1
duration of the loan. y of th6 borrower to default in their payments in the

Liquidity Risk is identif19d b .

all its currently mat . . . Yens_ur~ng the business to be capable of meeting
-- . th unng obligation. This 1s different in default risk Liquidity risk is
focusmg on e entire liquidity 0 f th · .
rt' f th . e company or its ability to service ,ts current
po ion. ~ eir debt as it comes due. In practice, this risk is quantified by
get~rmmiog the opportunity cost of the lender on the period within which the
borrowers were able to recoup or worst the value there cannot be salvage because
of the ability of the company to be liquid.

Legal risk is dependent on the covenants set and agreed in betw6en che
lenders and the borrowers. The legal risk will arise only upon the ability of any of
the parties to comply with the covenants of the contract. Normany, the burden is to
the borrower to comply given that the party who is obliged to pay back is them.
The common defaults in the covenants are as follows: (1) maintaining the financial
ratios; (2) significant acquisition or disposal of assets; (3) repayment of other
obligation; or (4) declaration of dividends of any form without the consent of the
lenders.
Market risk is the impact of the market drivers to the ability of the borrowers
to settle the obligation. Market risk is classified as a systematic risk because it
arises from external forces or based on the movement of t~e industry. Am.ong the
risks that affects the interest, market risk is the most difficult to q~ant1fy. The
experts and analysts can just only set certain parameters to measure 1t.

Mitigating the interest Rate Risks

. . t 1·s de endent on the inflation, tenor and other market

Since there intere ra ~
5t
n~ make reasonable estimates to mitigate these
51
risks. Companies should con er a res that the company may consider mitigating the
risks. Commercially, there are meas~ ment of the yield maybe normal or increasing,
impact of the interest rates. The mo" e

131 l
 ~~i
, .
inverted or dechntnQor flat or constant over time . figu re 5.1 pre'.sents the tra}ecto
'
ry Or
possibJe yteld ct1rves
Flat or Constont
inwrtl!d or o,«reasmg

1'

►
~
Q.)

CJ
____
.,....
t,
~

~
Time Time

Figure 5.1 Poss ible Yield Curve

Spot Rates
The yield curves presented in Figure 5.1 was a set ~f poin
ts of rate~ on a
particular maturity date . In a normal yield curve, most theo
nes expe_ct th at interest rates
increasing as the maturity lengthens . Although on the othe
r ~and,_y,e~d curve m~y
change or move drfferently as expected especially when
the inflation _,s decr~asmg , or
the purchasing power is improving. Spot rate is the
interest rate or yield available /
applicable for a particular time .
Spot rates are already _actual rates and are not hedge. Whe
n the agreement isa
spot rate the applicable interest rate is based on the prev
aiting market rate at the
parti.cular time . It is important to know the spot rates to be
used for estabHshing market
expectation in the future. Spot rates will be used to mitig
ate the risk by refecling to
historical yield vis-a-vis the forces that occur in those time
s. For examptG typhoon
occurred in the Metro Manila that causes the prices of the
resources to rise because of
the scarcity of resources resulting to increase in interest
rates. Upon noting the effect on
the spot rates of the external forces, we will expect in the
future that when such incident
will recur the spot rates will increase. Thus, it is incumbe
nt to the supplier of funds to
consider quantifying its effect so that the variability of rates
will be managed .
Forward Rates

.. Give~ that spot rates are very hard to determine precisely

, a way on how to
m1t1gate the impact to the ~ nder of fund 's return and on
the other hand the borrowers
cash flows to service the debt or loans in the future shou
ld the interest go beyond their
expectation, this is to have a forward rate or hedge rates
.
Forward rates ~re normally contracted rates tha!fJXed the
rates and allow .a
party to _assume such nsk on the difference between the cont
racted rate and the spot
rate. It 1s a challenge for _the financial consultants and
economic experts to determine
that most proba_ ble rates in the future. The clash will be that the lenders
would like a
more cothnservative rate white borrowers are aggressive
versus e expected spot rate in the future . or lower as much as possible
 FUNDA ET
. MENTALS OF FINANCIAL MARK
To illustrate, Oberon Finan .
on the market in the futu re cing Offers loa r •1

ase d M ns fixed aoA, 13nd

1

th~n organ a Corp. is for the first 5 years at

i,o for the next 10 years more
le of servicing the debt at only
9~os-Morgana Corp can enter into that they Will fail ~Pab
debt covenant
ra t 5 years and 9% for years 6 t 1 agreement With O maintain theirthe rates 8% for the
beron to have
~r~rest rate remains to be 8% un°. O. ihe risk on the
Part : Morgana Corp. if the
0
,nt er hand, if the rate results sa t,I Year 10, the corn Pany wrll lose 1% per year. On the
oth,, tract • . Y around 1oo,10 th en M
co organa gain for the forward rate
swaP Rate

Another way on how to mit' . .

· th · rgate the inte st rs enter into a swap rate.
ano er contract rate Wh . re rate rrsk
SwaP rate· is
t ·t usually the one ere a frxed ra te exchange for a certain market rate
at a certain .rr:ia un Y-
•t is normally the fixed portion of a cu rrenc used as reference is the LIBOR. For the swap rate,
, y swap.
UBOR or London Interbank Offered Rate is
hmar~ " • est rates wh,·ch .
Used to-benc .
inter ISUSedas
.
refere nce for inter natio nal bank s to borro w It . Point of Information!
calculated usin~ the Intercontinental Excha.ng~s or ICE or International
!CE. The rates ,~sued shor t term from 1 day up to Exchange was established in
1
2000 in Georgia , USA
year and releasing more than 30 rates based on gh it is in US it is
Althou
about five currencies. This is the reason why this rate subject to European Union
is used as the reference for consumer loans across regulators watch.
the world.
Financing and Morgana
For better·appreciation, with the illustration that Oberon
9% for years 6 to 10 but with a
Corp. borrowed at the rate of 8% for years 1 to 5 and
use the prevailing LIBOR rate on
clause that Morgana Corp and Oberon Financing may
the LIBOR rate is higher than
years 9 to 10. Thus, the risk for Morgana Corp. is when
the rate at the maturity.
is called the s~ap rate
The correlation of the swap rate and the maturity rate
nce for the credit risks and for
tieJticurve . The curve is useful for countries as refere
future decisions.

Credit Ratings
. and factors initially identified, another driver of
it rating affects the
Aside from the purc~asrng_ power the credit ratings. Cred
anies. The credit ratings are
the interest rate or risk cons ideration aret . s or comp
objectively assigns or
confidence level of the investors to coun r~e d globally that
ess of doing business with th~m .
determined by companies that a~e recognize the riskin
ge their liquidity and solvency rn
evaluates countries and companies b~se!-~~ to mana
their a , ,tyhe default risk associated to the country or
The riskiness is primarily driven dby the lower
the long run. The higher the gra e
133 l
 -------------------- --- -----..;···'-1RL
. '
pany. These three major r~ting com~arnes a~e: Sta ndard & Poor s Corporation
com_
~
(S&P); Moody's Investors Service; and Fitch Ratings.
Although, the credit ratings provided by these compani~s are just
recommendatory opinion and will serve ~s reference only and 15 not an absolutely
provide default probability to the companies.

Standard & Poors Corporation

Standard and Poor's Corporation or S&P is an American financial services

corporation was founded in 1941 by Henry Varnum Poor in New York, USA. The
company uses data gathered from 128 countries using more than 1,500 credit analyst
to assess the creditworthiness to the industry. The credit ratings provided by S&p w s
categorized to Investment Grade and Non-Investment Grade and scaled from AAA tere 0
as presented in Table 5.1. D
Table 5.1 S&P Credit Rating

AAA Extremely strong capacity to meet financial commitments r--.

AA Very strong capacity to meet financial commitments - s
~(/)
Strong capacity to meet financial commitments but susceptible to adverse economic -
A 3
(I)
conditions and changes in circumstances :)
...
G)
BBB Adequate capacity to meet financial commitments, but more subject to adverse economic- nl
conditions ~

BB Less vulnerable in the near-tenn but faces major ongoing uncertainties to advers
b .
usiness, financial and economic conditions
e -
B More vulnerable to adverse busi~ess, financial and economic conditions but currently has
the capacity to meet financial commitments
fJ)
"C
CCC Currently vulnerable and dependent
.. •
on favorable business , financial and economic (I)
Cl
conditions to meet financial commitments C
iiie
cc Highly vulnerable, default has not yet occurred , but expected to be a v1·rtu a1certainty
.
<
(I)

Cl
C al
. ' and ultimate reco very ·is expected to be lower
Currently highly vulnerable to non-payment C.
(D
than that of higher rated obligations
D Payment default on a financial commitment or breach of .
when a bankruptcy petition has been filed or s~~;~~~~~i~i;~;ise;en.
also used

Moody's Investors Service

Moody's Investors Services or Mood , .18 . .

debt securities established in 1909 in New / s credit rating company particularly o~
from more than 130 countries, more than 4 ork, US~. The_company gathers information
,OOO non-financial corporate issues and more

134 !
,,..,.,,,-,-- ----!, _UNDAMENTALS OF FINANCIAL MARKET
. . .
4 ooo f1nanc1al institutions Th e co
than world.1

, le mpany em I
•

wl1° Poys more than 13 000 acros s the

Moody's classify the credit s . '
4 nd1
ta ng into th 8 .
• scale . ratings in Table 5.2 for the Moody's
r,wtinQ

Table 5.2 MOOdy' R

s ating Scale
_,-
Obligations rated Aaa are jud
Aaa risk. ged to be of the highest .
quahty, subject to the lowest level of credit
i---
Aa Obligations rated Aa are jud ged to be of hi h .
g quality and are subj ct . .
i.-- e to very low credit risk.
Obligations rated A are jud ed
A 9 to be upper-m ec1·
~ . . - ,um grade and are subject to low credit risk .
saa Obligations rated Baa are judg d
· e to be medium d as
such may posses s certain speculative charact -wa e and subject to moderate credit risk and
enstics .
i.--

ea Obligations rated Ba are judged t0 be speculative and .

are subJect to substantial credit risk .
- B Obligations rated B are considered s .
peculat,ve and are subject to high credit risk.
- .
Obligations rated Caa are judged to be speculative
caa
credit risk . of poor standing and are subject to very high

-ca Obligations rated Ca are highly speculative an . .

near, default, with some
prospect of recovery of principal and interest. d are hkely in, or very

- ·
Obligations rated C are the lowest rated an d are typically
C of principal or interest. m default, with little prospect for recove ry

Fitch Ratings
The third credit rating agency is Fitch Ratings. It was founded
in 191 4 in New
information and
York, USA. The company was owned by Hearst. Hearst is a global
expectations based
services company. Fitch provides credit opinions based on the credit
ny, they assess
on the certain quantitative and qualitative factors that drive a compa
assessment
based on the credit analysis and intensive resea rch . They condu ct their
curren cies.
over more than 8 000 entities around the globe with 25 different
I

Fitch same with the other rating agencies publishes its opinion
based on a
ts the rating
certain scale of rating s to represents their opinion. Table 5.3 presen
5
definition of Fitch Ratings ,

4
}.l&w.moody.;.rnm

5
OYiP. .'fJ.Lw1r,; w.fitchr2ti ngs,con1/siteLEf..tlW1tionJ 135 I
 ~UNO,\Mf N1Al~ OF f lNANCIAL f.A,
Vj$' ~,(f

~--
Table 5.3 Fi1ch Rating Scale

AAA 1--hght!St credit qualtty

-
Vert tugh crech! quality
AA

A High credrt quahty

-
888 Good credit quahty

88 Speculative

B Highly speculative

CCC Substantla liy credit nsk

cc Very high levels of credit risk

C Near default

RD Restricted Default

D Default

In 2019 , Philippines was assessed by S&P at BBB

with a stable ~utlook while
Fitch last evaluation was in 2017 at BBB also with
stable outlook. Moody s on the other
hand , rated the country in 2014 at Baa with stab
le rating.
United States were rated as AAA by Fitch in 2014
with stable outlook. Moody's
rating is Aaa with stable outlook in 2013, while S&P
's latest rating in 2013 with stable
rating at AA.
Other rating agencies
There are othe r credit rating agencies other than
the three major like DBRS and
CARE Ratings. Unlike S&P , Moody's and Fitch,
these credit rating agencies were not
located in the United States.
DBRS was established in 1976 in Toronto, Can
ada. The company was
considered as the fourth largest ratings agency.
The company observe almost 50,000
securities worldwide. DBRS also has offices in New
York, Chicago, London, Frankfurt
and Madrid ln Spain6 . The rating follows from AAA
to C as the least.
CARE Ratings started its operation in 1993 base
d in India . The company is
based in Mumbai with partners in Brazil, Portugal,
Malaysia and South Africa. Other than
Mumbai they also have about 10 regional officers
that aims to provide information to
investors to serve as guide as they enter into new
investment. They also use AAA as the
best instrument to D as the least.

6
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 I '--~ -~ ~
~O~FJF~IN~.A~N~C~IA~L~M~A~R;_K£_~T
~ , _ . .- - - - - - - - - - - - -!F~U~ND~A~M~E~N~T~A~LS

suMMARY
· to
one of the challenges in finan · 15 ensure the ability of the borro~e~s .
• rtle the obligation Th . ~ing t~
se . · e nsk involve 1n financing are·· defau lt risk, liq uidity
risk, and mark et nsk among others .

is affected by the
• It i~ . th_~oretically assumed that the cost of finan cing
ava1lab1llty of loanable funds which is the Loanable Fund
s Theory and the
th the higher the rate
maturity of e loans , where the longer the life of the loans
is Liquidity Prefe rence Theory.

(2) risk exposure;

• The three factors t~at affect the interest rates: (1) industry;
t11e interest for~ula
and (3) compensation for the market expectation. Hence,
and debt premium
will require the function of default or risk-free rate, inflation
for the compensation.

rd rates or enter
• In order to mitigate the risk, most businesses hedge forwa
wers and lenders ~o
into a swap rate agreement. It is important for the borro
and employ certain
know what the spot rate in the prevailing market is
expectations in the future .
~

137 I