CHAPTER 5 – MANAGING THE

CREDIT RISK OF FINANCIAL

INSTRUMENT
 CREDIT RISK

• A type of business risk.

• Risk that the borrower was not able to repay its obligation.
• A factor to determine the cost of lending or financing using
debt.
 THEORIES RELATED IN SETTING
INTEREST RATES
• LOANABLE FUNDS THEORY
Assumes that it is ideal to supply funds when the interests are
high and vice versa. It was introduced by Knut Wicksell in
1900s.

• LIQUIDITY PREFERENCE THEORY

Interest rates are dependent on the preference of the household
whether they hold or use it for investment.
 INTEREST RATES

• According to BSP, interest rate is a type of price.

• For lenders, interest rate is called lending rate or return.
• For borrowers these will serve as cost of debt.
• There are two theories that affect the term structure of interest
rate : (1)Expectation Theory and (2) Market Segmentation
Theory
 EXPECTATION THEORIES

• According to this theory, interest rates are driven by expectation of the

lender or borrowers in the risks of the market in the future. This maybe :
• (1)Pure Expectation Theory – based on current data and statistical
analysis to project the behavior of the market in the future ; and
• (2)Biased Expectation Theory – includes that there are factors that affect
the term structure of the loans as well as the interest to be perceived
moving forward. Forward rates will be affected/adjusted if the liquidity
of the borrower will be weaker or stronger in the future. This adjustment
or increase is called liquidity premium.
Liquidity Theory – liquidity premium increases as the maturity lengthens.
Preferred Habitat Theory – does not consider only the liquidity but the risk
premium as well but disregarding the consensus of the market on the future interest
rates.
MARKET SEGMENTATION THEORY

• It assumes that the driver of the interest rates are the savings
and investment flows.
DETERMINATION OF INTEREST RATES

• Factors considered are :

1. Interest rates in industry
2. Risk exposure
3. Compensation on the market expectation

i = (Rf + Dm)
i = interest
Rf = risk free rate where (Real risk free rate = Rf minus inflation)
Dm = debt margin/debt spread/risk premium
 RISK FREE RATE

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 is the Treasury bill issued by the republic. In the
Philippines, it can be referred in the Philippine Dealing Systems
Of PDS Group.
Risk free rates excludes the effect of inflation (or the effect of
purchasing power of the Philippine peso), hence to compute for
the Real Risk Free Rate, prevailing inflation must be deducted.
 ILLUSTRATION

• Morgana Corporation 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 Morgan Corp.

First, compute for Real Risk Free rate :

Rfr = Rf – inflation
Rfr = 6% - 2%
Real Risk Free Rate = 4%
• The real risk free rate computed is 4%. Since the repayment will
be made in the future , Oberon should consider the forecasted
inflation. Transposing the formula to determine the risk free rate
in the future and incorporate the 3% inflation forecast :
Rf = (Rfr + Inflation)
Rf = 4% + 3% = 7%
The nominal risk free rate applicable for the loan is 7%. To
calculate the applicable return that Oberon Financing need in order
to kept them whole by
i = 7% + 4%
i= 11% (The interest rate that Oberon should charge to Morgan)
 Another way to calculate interest is by function of the
market value, par value, and the interest expense paid by
debt securities or bonds

I+((V-M)/n)
i= x 100%
((V+M)/2)

• i = interest rate
• I = periodic interest payments
• V = par value of bonds
• M = Market value of bonds
• n = term of bonds
 ILLUSTRATION

• Merlin Corporation issued bonds with 10% nominal rate for a

Php, 1000 par value bond payable for 20 years. The bonds
were sold for P1,200. How much is the interest rate of the
Merlin bonds in the market?
 DIFFERENT RISKS
• Default Risk – inability to make payment consistently.
• Liquidity Risk – focuses on the entire liquidity of the company
or its ability to service
• Legal Risk – dependent on the covenants set and agreed in
between the lenders and the borrowers
• Market Risk – impact of the market drivers to the inability of
the borrowers to settle the obligation.
 MITIGATING INTEREST RATE RISK

• Spot Rates – applicable interest rate is based on the prevailing

market rate at the particular time

• Forward Rates – 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

• Swap Rate – a contract rate where a fixed rate exchange for a

certain market rate at a certain maturity (usually the one used
as a reference is the LIBOR or London Interbank Offered
Rate)
 CREDIT RATINGS

• Another driver of interest rate or risk consideration

• Determined by globally recognized companies that objectively
assigns or evaluates countries and companies based on the
riskiness of doing business with them.
• The higher the grade, the lower the default risk.
• These are just recommendatory opinions and will serve as
reference only.
 CREDIT RATING COMPANIES

• STANDARD AND POOR’S CORPORATION

American financial services corporation founded in 1941 by Henry Varnum Poor in New
york, USA.

• MOODY’S INVESTORS SERVICE

A credit rating company particularly on debt securities established in 1909 in New York,
USA.

• FITCH RATINGS
Founded in 1914 in New York USA. This company is owned by Hearst, a global information
and services company.

• Other rating agencies

Dominion Bond Rating Service (DBRS) (Canada) and Credit Analysis and Research Ltd
(CARE) (India)
CREDIT RATING SCALES