MANAGING THE

CREDIT RISK IN
FINANCIAL MARKET
LEARNING OBJECTIVES
• Identify the different levels and methods of rating entities;
• Make recommendation on the results of liquidity and solvency; and
• Understand how to improve value of collaterals.
RISK AND RETURN
Risk - the chance of financial loss or the variability of returns associated with a given asset.

Example:

Scenario 2 - A P10,000 investment in

Scenario 1 - A P10,000 government
stocks which will earn between 0%-10%
bond with P500 interest after 30 days.
after 30 days.

Note: The more nearly certain the return from an asset, the less variability and therefore, the
less risk.
RISK AND RETURN
Return - the total gain or loss experienced on an investment over a period of time. It is
calculated by dividing the asset’s cash distributions during the period, plus change in value,
by its beginning investment value.

Formula:
r = (CF + CV – BI) / BI

where:
r = actual, expected or required rate of return
CF = cash flow received in the time period
CV = current value of the asset
BI = initial investment
RISK AND RETURN
Example:
ABC Company wishes to determine the return of its two machines, A and B.

Machine A was purchased 1 year ago for Machine B was purchased 4 years ago
P20,000 and currently has a market value for P12,000 and currently has a market
of P21,500. During the year, it generated value of P11,800. During the year, it
P800 (after tax). generated P1,700 (after tax).

r = (CF + CV – BI) / BI r = (CF + CV – BI) / BI

r = (800 + 21,500 – 20,000) / 20,000 r = (1,700 + 11,800 – 12,000) / 12,000
r = 23,000 / 20,000 r = 1,500 / 12,000
r = 11.50% r = 12.50%
RISK ASSESSMENT TOOLS
• Scenario Analysis
• Probability Distribution
SCENARIO ANALYSIS
It uses several possible alternative outcomes (scenarios) to obtain a sense of the variability
among returns:
• pessimistic (worst)
• most likely (expected)
• optimistic (best)
SCENARIO ANALYSIS
Example:
ABC Company wants to choose the better between the two investments, A and B. Each
requires an initial investment of P10,000 and each has a most likely annual rate of return of
15%.
Asset A Asset B
Initial Investment 10,000 10,000
Annual Rate of Return
Pessimistic 13% 7%
Most Likely 15% 15%
Optimistic 17% 23%
Range 4% 16%
The range is the difference between the pessimistic and optimistic outcomes. The greater the
range, the more variability or risk.
PROBABILITY DISTRIBUTION
• It provides a more quantitative insight into an asset’s risk. The probability of a given
outcome is its chance of occurring.
• It is a model that relates probabilities to the associated outcomes. Probability is the chance
that a given outcome will occur.
PROBABILITY DISTRIBUTION
Example:
Assuming the previous example, ABC Company’s past estimates indicate that the
probabilities of the pessimistic, most likely and optimistic outcomes are 25%, 50% and 25%,
respectively.
PROBABILITY DISTRIBUTION
Example:

Although Assets A and B have the same most likely return, the distribution of returns for Asset
B has more greater dispersion than the distribution for Asset A. Clearly, Asset B is more risky
than Asset A.
RISKS IN FINANCIAL TRANSACTION
• Default/Credit risk - the risk that the borrower may not be able to repay its obligation. It is
included in valuation as a factor to determine the cost of lending or financing using debt.
• Liquidity risk - focuses on the entire liquidity of the company or its ability to service its
current portion of their debt as it becomes due.
• Legal risk - is dependent on the covenants set and agreed in between the lenders and the
borrowers. It will only arise upon the ability of any of the parties (lender or borrower) to
comply with the covenants in the contract.
• Market risk – is the impact of the market drivers to the ability of the borrowers to settle the
obligation. It is classified as a systematic risk because it arises from external forces or based
on the movement of the industry.
CREDIT RATING
• It is a driver of the interest rate or risk consideration that affects the confidence level of the
investors.
• The riskiness is primarily driven by their ability to manage the liquidity and solvency in the
long run. The higher the grade is, the lower is the default risk.
• Three major rating companies:
• Standard and Poor’s Corporation (S&P) – founded in 1941 by Henry Varnum Poor to
assess credit worthiness of an industry.
• Moody’s Investors Service (Moody) – founded in 1909 to provide credit rating on debt
securities.
• Fitch Ratings – founded in 1914 and owned by Hearst to provides credit opinions
based on the credit expectations on certain quantitative and qualitative factors that
drive a company.
INTEREST RATE
• It is the compensation paid by the borrower of funds to the lender.
• It is the cost of borrowing funds from the point of view of the borrower.
INTEREST RATE THEORIES
• Classical Theory
• Loanable Funds Theory
• Liquidity Preference Theory
• Expectations Theory
• Pure Expectations Theory
• Biased Expectations Theory
• Market Segmentation Theory
CLASSICAL THEORY
• It states that the interest rate is determined by the
interaction of demand and supply for capital.
• The point where the demand for and supply of
capital meet is the point of the interest rate.
• This is also known as the real theory of interest
because it is based on real forces of demand and
supply.
• There is a direct relationship between interest rate
and supply of fund/savings.
• There is an indirect relationship between interest
rate and demand for fund/capital.
LOANABLE FUNDS THEORY
• It was introduced by Knut Wicksell in 1900.
• It states that the rate of interest is determined
by the demand for and supply of loanable
funds.
• It assumes that it is ideal to supply funds
when the interest rates are high and vice
versa.
• There is a direct relationship between Interest
rate and supply of loanable funds.
• There is Indirect relationship between Interest
rate and demand of loanable funds.
LIQUIDITY PREFERENCE THEORY
• It was introduced by John Maynard Keynes.
• It states that the interest rate is determined by the
supply and demand for money.
• It assumes that interest rates are dependent on the
preference of the household whether they hold or use
it for investment.
• The longer the term, the higher the rates because
investors preferred the short-term investment.

Example:
There are three treasury note: a 3-year treasury note with
2% interest rate, a 10-year treasury note with 4% interest
rate and a 30-year treasury note with 6% interest rate.

For the investor to sacrifice liquidity, they must receive a

higher rate of return in exchange for agreeing to have
the cash tied up for a longer period of time.
EXPECTATIONS THEORY
• It states that the interest rates are driven by the expectation of the lenders or borrowers in
the risk of the market in the future:
• Pure Expectations Theory
• Biased Expectations Theory
• Both theories understand how the interest rate or the term should be structured over time.
EXPECTATIONS THEORY – PURE EXPECTATIONS
• It is based on the current data and statistical analysis to project the behavior of the market
in the future.
• Lenders/Borrowers rely on the future interest rates based on their projection on the future
prices.
• The expectation on the interest rates varies depending on the perspective and the maturity.

Example:
Let's say that the present bond market provides investors with a two-year bond that pays an
interest rate of 20% while a one-year bond pays an interest rate of 18%. The expectations
theory can be used to forecast the interest rate of a future one-year bond.
EXPECTATIONS THEORY – BIASED EXPECTATIONS
• It states that there are other factors affecting the term structure of the loans as well as the
interest to be perceived.
• The forward rates will be adjusted/affected if the liquidity of the borrower will be
weaker/stronger in the future.
• The adjustment on the interest rate is called liquidity premium.
• The liquidity premium increases as the maturity lengthens (Liquidity Theory).
• Preferred Habitat Theory – it considers both the liquidity and risk premium but disregards
the consensus of the market on the future interest rate. The habitat being referred is the
biased estimate over the market behavior in the future.
MARKET SEGMENTATION THEORY
• It assumes that the driver of the interest rates is 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.
• It is the same as the preferred habitat theory but it does not assume that any of the players
are willing to shift sector should the opportunity arise for the assets/liabilities to be retired
or lenders to offer higher rates.
REAL VS NOMINAL/ACTUAL RATE OF INTEREST
Real Rate of Interest – it is the rate that creates an equilibrium between the supply of savings
and the demand for investment fund in a perfect word without inflation.

Nominal/Actual Rate of Interest – it is the actual rate of interest charged by the supplier of
funds and paid by the demander.
FACTORS AFFECTING INTEREST RATES
• Industry
• Risk exposure
• Compensation for the market expectation
DETERMINATION OF INTEREST RATE
• The interest rate can be determined by the function of the risk and the compensation of
the investor on the difference between the risk-free rate and the market fluctuations:

• The risk-free rate can be real or excludes the effect of inflation or the exclusion of the effect
of the purchasing power of money.
• Since the real risk-free rate excludes the inflation, the nominal which is the risk free adjusted
for inflation may assume a compounding effect in the future. Therefore, the real risk-free
rate can be determined by deducting the prevailing inflation:
DETERMINATION OF INTEREST RATE
Example:
ABC Company would like to borrow funds from DEF Company. The risk-free rate is 6% and
the current inflation is 2%. For the following year, the inflation is expected to grow to 3%. DEF
still finds that the 4% margin remains to be relevant. How much is the interest rate that DEF
should impose to ABC?
Risk-free rate = real risk-free rate +
Interest rate = risk-free rate + risk inflation rate
premium Risk-free rate = 4% + 3%
Risk-free rate = 7%
Real risk-free rate = risk-free rate – Interest rate = risk-free rate + risk
inflation rate premium
Real risk-free rate = 6% - 2% Interest rate = 7% + 4%
Real risk-free rate = 4% Interest rate = 11%
DETERMINATION OF INTEREST RATE
• Another way on how to calculate the interest rate is by the function of the market value, par
value and the interest expense paid by debt securities or bonds:
DETERMINATION OF INTEREST RATE
Example:
ABC Company issued bonds with 10% nominal rate for a P1,000 par value bond payable for
20 years. The bonds were sold for P1,200. How much is the interest rate of the bonds in the
market?

Interest rate = [(100-10)/1,100)]/100%

Interest rate = 0.0818 x 100%
Interest rate = 8.18%
TIME VALUE OF MONEY
• The time value of money is one of the
most important concepts in finance.
• Money that the firm has in its possession
today is more valuable than money in
the future because the money it now has
can be invested and earn positive
returns.
• Time value is based on the belief that a
peso today is worth more than a peso
that will be received at some future date:
• Future Value – it measures cash flows
at the end of a project's life.
• Present Value – it measures cash
flows at the start of a project's life
(time zero).
TIME VALUE OF MONEY
Basic Patterns of Cash Flow:
• Single Amount – a lumpsum amount either currently held or expected at some future date.
Example is P650 today to be received at the end of 5 years at P1,000.
• Annuity – a level of equal periodic stream of cash flow. Example is P1,000 today to be paid
P200 annually for 5 years.
• Mixed Stream – a stream of unequal periodic cash flow that reflects no particular pattern.
Example is P1,000 today to be paid P100 in the 1st year, P300 in the 2nd year, P200 in the
3rd year, P150 in the 4th year and P250 in the 5th year.
SIMPLE INTEREST VS COMPOUND INTEREST
Simple interest - is the interest calculated on the principal portion of a loan or on the original
contribution to a savings account.

Compound interest - is calculated by adding interest earned on prior periods of a loan or

deposit to the principal amount. Therefore, successive interest payments are calculated on
prior interest earned plus principal, which results in higher interest payments at every
payment interval of the asset.
SIMPLE INTEREST VS COMPOUND INTEREST
Example:
ABC Company obtains a simple-interest loan amounting to P750,000 with an annual interest
rate of 3% to be used in building improvement. ABC will repay the loan over five years.

Year Principal Interest Balance

0 - - 750,000.00
1 750,000.00 22,500.00 772,500.00
2 750,000.00 22,500.00 795,000.00
3 750,000.00 22,500.00 817,500.00
4 750,000.00 22,500.00 840,000.00
5 750,000.00 22,500.00 862,500.00
SIMPLE INTEREST VS COMPOUND INTEREST
Example:
ABC Company obtains a loan amounting to P750,000 with a compounding annual interest
rate of 3% to be used in building improvement. ABC will repay the loan over five years.

Year Principal Interest Balance

0 - - 750,000.00
1 750,000.00 22,500.00 772,500.00
2 772,500.00 23,175.00 795,675.00
3 795,675.00 23,870.25 819,545.25
4 819,545.25 24,586.36 844,131.61
5 844,131.61 25,323.95 869,455.56
MITIGATING THE INTEREST RATE RISKS
• The interest rate is dependent on the inflation, tenor and other market risks.
• Companies should consider and make reasonable estimates to mitigate these risks:
• Forward contract – is a customized contract between two parties to buy or sell an asset
at a specified price on a future date.
• Swap contract – is a financial derivative that allows two transacting agents to “swap”
revenue streams arising from some underlying assets held by each party. Interest rate
swaps allow their holders to swap financial flows associated with two separate debt
instruments.
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