TITLE: “Managing Credit Risk in Money Market”

First, what is Credit Risk?

 Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet
contractual obligations.

Why do we need to manage credit risk?

 Credit risk management is the practice of mitigating those losses by understanding the
adequacy of a borrower’s capital and loan loss reserves.

Basic steps in managing credit risk

1. Check potential customers credit scores

2. Draft your credit lending terms
3. Build good customer relationships
4. Develop a standard process for overdue accounts

Advantages of Managing Credit Risk

• It helps in predicting and/ or measuring the risk factor of any transaction.

• It helps in planning ahead with strategies to tackle a negative outcome.

• It helps in setting up credit models which can act as a valuable tool to determine the level of risk
while lending.

What is Credit ratings?

 They provide a commonly recognized source of independent opinions on creditworthiness,

which can serve as a useful starting point for assessing the credit quality of counterparties and
their financial instruments.

Three major rating companies are:

1. Standard & Poor’s Corporation (S&P) - An American financial services corporation was founded
in 1941 by Henry Varnum Poor in New York, USA. The credit ratings provided by S&P were
categorized to investment Grade and Non-Investment Grade and scaled from AAA to D

2. Moody’s investor Service - A credit rating company particularly on Debt securities established in
1909 in New York, USA.

3. Fitch Ratings - Founded in 1914 in New York, USA. The company was owned by Hearst. Fitch
provides credit opinions based on credit expectations based on a certain quantitative and
qualitative factors that drive a company.

Credit Information System

The credit information system is intended to straightforwardly address the need for dependable credit
information of borrowers and is supposed to significantly improve the overall availability of credit to
make credit more cost-effective.
Credit Information System Act

The Credit Information System Act of 2008 (Republic Act No. 9510) also known as CISA is the act
establishing Credit Information Corporation.

Credit Information Corporation (CIC)

The Credit Information Corporation (CIC) is a government-owned and controlled corporation providing
credit information system in the Philippines. It was created in 2008 by the Credit Information System Act
(CISA)

Theories related in Setting Interest Rates

According to Fabozzi and Drake, there are two economic theories that drives the interest rates.

1. Loanable funds Theory - Assumes that it is ideal to supply funds when the interests are high and
vice versa. Introduced by Knut Wicksell in 1900s.

2. Liquidity preference theory - Introduced by John Maynard Keynes that the interest rates are
dependent on the preference of the household whether they hold or use it for investment.
Thereby that the longer the term the higher the rates because investors preferred the short-
term investment more.

For lenders, interest rate is called as lending rate or return. For the borrowers, these will serve as cost
of debt.

Two economic Theories that affect the term structure of interest rate

1. Expectations theory - Interest rates are driven by the expectation of the lender or borrowers in
the risks of the market in the future.

a) Pure Expectation Theory - They all rely on the forward and future interest rates based
on their projection on the future prices.

b) Biased expectation theory

 Liquidity premium - the adjustment or increase on the interest rate.

 Liquidity theory - Liquidity premium increases as the maturity lengthens.
 Preferred habitat theory - this theory does not only consider the liquidity but the risk premium
as well but disregarding the consensus of the market on the future interest rates

2. 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 financing.

Cost of Debt

 The cost of debt is the minimum rate of return that debt holder will accept for the risk taken,
effective interest rate a company pays on its debts. The cost of debt often refers to after-tax
cost of debt.
Formula:

Cost of Debt = effective interest rate (1 - tax rate)

Example:

CBA company took a loan amounting to $200,000 from a bank at 8% interest rate. Tax rate is 30%

Cost of Debt = effective interest rate (1 - tax rate)

= 8% (1-30%)

= 5.6%

Cost of Debt = $200,000 x 5.6%

= $11,200

Managing Liquidity and Solvency

Both solvency and liquidity refer to a company’s state of financial health, however the two terms are
different.

What is Liquidity?

Liquidity – Ability of a firm, company, or even an individual to pay its debts without suffering
catastrophic losses.

- Investors, lenders, and managers all look to a company’s financial statements using liquidity
measurement ratios to evaluate liquidity risk.

Liquidity risk- it arises when a money in money market fund experiences unexpected large cash
outflows.

• When a buyer cannot find a seller at the current price, he or she must usually raise his or her bid
to entice someone to part with the asset. And seller who must reduce their ask prices to
persuade buyers.

What is Solvency?

Solvency- is the ability of the firm to meet long-term obligations and continue to run its current
operations long into the future.

A solvent company is one whose current assets exceed its current liabilities, the same applies to
an individual or any entity.

A firm’s solvency ratio can affect its credit rating – the lower the ratio the worse its rating can
become.

Collateral value- refers to the fair market value of the assets used to secure a loan.
Determination of interest rate

In finance, interest can be determined by the function of the risk

Formula:

i = (Rf + Dm)

I = interest
Rf = risk free rate (Real risk free rate Rfr = Rf – Inflation)
Dm = debt margin or debt spread or the risk premium

Risk-free rate – should the rate that assumes zero default in the market where this is more or less
equivalent to the rates offered by the sovereign. The normal basis of the risk free rate is Treasury Bills
issued by the republic. In the Philippines, this can also be referred in the Philippine Dealing Systems or
PDS Group.

Example:

Morgana Corp. would like to borrow funds from Oberon Financing. The risk free rate is 6% and the
current inflation is 2%. In the following year, the inflation is expected to grow to 3%. Oberon still finds
that the 4% margin remains to be relevant. How much is the interest rate that Oberon Financing should
impose to Morgana Corp.?

Rfr = (Rf - Inflation) Rf = (Rfr + Inflation)

Rfr = 6% - 2% Rf = 4% + 3%

Rfr = 4% Rf = 7%

i = (Rf + Dm)

i= 7% + 4%

i = 11%

Therefore, the interest rate that Oberon Financing should charge Morgana is 11%

The function of the market value, par value and the interest expense paid by debt securities or bonds.

i=
I+ ( V −M
n )
x 100 %
V +M
2
i = interest rate

I = periodic interest payment

V = par value of bonds

M= market value of bonds

n = term of bonds

Examples:

Merlin Corporation issued bonds with 10% nominal rate for a Php1,000 par value bond payable for 20
years. The bonds were sold for Php1,200. How much is the interest rate of the Merlin bonds in the
market?

i=¿ ¿

i=
100+ ( −200
20 )
x 100 %
2,200
2
100−10
i= x 100 %=8.18 %
1,100
Premium 10% < 8.18%
This means that the same bonds are perceived to be riskier in the market as compared to the nominal
rate.

Risk that are inherent in every financing transaction

1. Default Risk- arise on the inability to make consistently payment. This type of risk may be
quantified by determining the probability of the borrower to default in their payments in the
duration of the loan.

2. Liquidity Risk- is identified by ensuring the business to be capable of meeting all its currently
maturing obligation. It also focusing on the entire liquidity of the company or its ability to
service its current portion of their debt as it comes due.

3. Legal Risk- dependent on the covenants set and agreed in between the 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.

4. Market Risk – is the impact of the market drivers to the ability of the borrowers to settle the
obligation.
The movement of the yield maybe normal or increasing, inverted or declining or flat or constant over
time.
Interest Rate Yield

Normal or increasing

Inverted or Decreasing
Time

Interest Rate Yield

Time
Interest Rate Yield

Flat or Constant

Time

• Spot rate – is the interest rate or yield available/applicable for a particular time. It will be used
to mitigate the risk by referring to historical yield that occur in those times.

• Forward rates- are normally contracted rates that fixed the rates and allow a party to assume
such risk on the difference between the contracted rate and the spot rate.

• Time
Swap rate- where a fixed rate exchange for a certain market rate at a certain maturity.

• The correlation of the swap rate and the maturity rate is called the swap rate yield
curve.