Spot Rates

The yield curves presented in Figure 5.1 was a set of points of rates on a particular maturity date. In a
normal yield curve, most theories expect that interest rates increasing as the maturity lengthens.
Although on the other hand, yield curve may change or move differently as expected especially when
the inflation is decreasing, 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. When the agreement is a spot rate the applicable
interest rate is based on the prevailing market rate at the particular time. It is important to know the
spot rates to be used for establishing market expectation in the future. Spot rates will be used to
mitigate the risk by referring to historical yield vis-à-vis the forces that occur in those times. For
example, a 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 incumbent to the supplier of funds to consider quantifying its effect so that the
variability of rates will be managed Forward Rates

Given that spot rates are very hard to determine precisely, a way on how to mitigate the impact to the
lender of fund's return and on the other hand, the borrower's cash flows to service the debt or loans in
the future should the interest go beyond their expectation, this is to have a forward rate or hedge rates.

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. It is a challenge for the financial
consultants and economic experts to determine that most probable rates in the future. The clash will be
that the lenders would like a more conservative rate while borrowers are aggressive or lower as much as
possible versus the expected spot rate in the future.

To illustrate, Oberon Financing offers loans fixed for the first 5 years at 8% and based on the market in
the future. Morgana Corp. is capable of servicing the debt at only 9% for the next 10 years more than
that they will fail to maintain their debt covenant ratios. Morgana Corp can enter into agreement with
Oberon to have the rates 8% for the first 5 years and 9% for years 6 to 10. The risk on the part of
Morgana Corp. if the interest rate remains to be 8% until year 10, the company will lose 1% per year. On
the other hand, if the rate results say around 10% then Morgana gain for the forward rate contract.

Swap Rate

Another way on how to mitigate the interest rate risk is enter into a swap rate. Swap rate is another
contract rate where a fixed rate exchange for a certain market rate at a certain maturity. Usually the one
used as reference is the LIBOR. For the swap rate, it is normally the fixed portion of a currency swap.

LIBOR or London Interbank Offered Rate is used to benchmark interest rates which is used as Point of
Information! reference for international banks to borrow. It is calculated using the Intercontinental
Exchange or
ICE or International ICE. The rates issued short term from 1 day up to 1

Exchange was established in

2000 in Georgia, USA year and releasing more than 30 rates based on

Although it is in US it is 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

For better appreciation, with the illustration that Oberon Financing and Morgana Corp. borrowed at the
rate of 8% for years 1 to 5 and 9% for years 6 to 10 but with a clause that Morgana Corp and Oberon
Financing may use the prevailing LIBOR rate on years 9 to 10. Thus, the risk for Morgana Corp. is when
the LIBOR rate is higher than the rate at the maturity.

The correlation of the swap rate and the maturity rate is called the swap rate yield curve. The curve is
useful for countries as reference for the credit risks and for future decisions

Credit Ratings

Aside from the purchasing power and factors initially identified, another driver of the interest rate or
risk consideration are the credit ratings. Credit rating affects the confidence level of the investors to
countries or companies. The credit ratings are determined by companies that are recognized globally
that objectively assigns or evaluates countries and companies based on the riskiness of doing business
with them. The riskiness is primarily driven by their ability to manage their liquidity and solvency in the
long run. The higher the grade the lower the default risk associated to the country or company. These
three major rating companies are: Standard & Poor's Corporation (S&P); Moody's Investors
Service; and Fitch Ratings.

Although, the credit ratings provided by these companies are just recommendatory opinion and will
serve as reference only and is not an absolutely provide default probability to the companies.

Standard & Poor's 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 analysts to assess the creditworthiness to the industry. The credit ratings
provided by S&P were categorized to Investment Grade and Non-Investment Grade and scaled
from AAA to D as presented in Table 5.1.

Table 5.1 S&P Credit Rating

AAA

Extremely strong capacity to meet financial commitments

AA

Very strong capacity to meet financial commitments

Strong capacity to meet financial commitments but susceptible to adverse economic

conditions and changes in circumstances

Investment Grade

BBB

Adequate capacity to meet financial commitments, but more subject to adverse economic

conditions

BB

Less vulnerable in the near-term but faces major ongoing uncertainties to adverse

business, financial and economic conditions

More vulnerable to adverse business, financial and economic conditions but currently has

the capacity to meet financial commitments

CCC

Currently vulnerable and dependent on favorable business, financial and economic

conditions to meet financial commitments

Speculative Grade

CC

Highly vulnerable, default has not yet occurred, but expected to be a virtual certainty

Currently highly vulnerable to non-payment, and ultimate recovery is expected to be lower

than that of higher rated obligations

Payment default on a financial commitment or breach of an imputed promise; also used

when a bankruptcy petition has been filed or similar action taken.

Moody's Investors Service

Moody's Investors Services or Moody's is credit rating company particularly on debt securities
established in 1909 in New York, USA. The company gathers information from more than 130 countries,
more than 4,000 non-financial corporate issues and more than 4,000 financial institutions. The company
employs more than 13,000 across the whole world.

Moody's classify the credit standing into the ratings in Table 5.2 for the Moody's Rating Scale

Table 5.2 Moody's Rating Scale

Aaa

Obligations rated Aaa are judged to be of the highest quality, subject to the lowest level of credit risk

Аа |

Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.

Obligations rated A are judged to be upper-medium grade and are subject to low credit risk.

Baa

Obligations rated Baa are judged to be medium-grade and subject to moderate credit risk and as such
may possess certain speculative characteristics

Ba

Obligations rated Ba are judged to be speculative and are subject to substantial credit risk

Obligations rated B are considered speculative and are subject to high credit risk.

Caa

Obligations rated Caa are judged to be speculative of poor standing and are subject to very high credit
risk.

Са

Obligations rated ca are highly speculative and are likely in, or very near, default, with some prospect of
recovery of principal and interest
Obligations rated C are the lowest rated and are typically in default, with little prospect for recovery of
principal or interest

Fitch Ratings

The third credit rating agency is Fitch Ratings. It was founded in 1914 in New York, USA. The company
was owned by Hearst. Hearst is a global information and services company. Fitch provides credit
opinions based on the credit expectations based on the certain quantitative and qualitative factors that
drive a company, they assess based on the credit analysis and intensive research. They conduct their
assessment over more than 8,000 entities around the globe with 25 different currencies.

Fitch same with the other rating agencies publishes its opinion based on a certain scale of ratings to
represents their opinion. Table 5.3 presents the rating definition of Fitch Ratings.

Table 5.3 Fitch Rating Scale

AAA

Highest credit quality

AA

Very high credit quality

High credit quality

BBB

Good credit quality

BB

Speculative

Highly speculative

Substantially credit risk

Very high levels of credit risk

Near default

Restricted Default

Default
In 2019, Philippines was assessed by S&P at BBB with a stable outlook 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 stable 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 other 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, Canada. 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 in Spain. The rating follows from AAA to C as the least.

CARE Ratings started its operation in 1993 based 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.