Republic of the Philippines

POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

Module 5 – Managing the Credit Risk of the Financial Instrument

Overview
Credit Risk is the possibility of loss resulting from a borrower’s failure to repay a loan or meet
contractual obligations. In order to mitigate this risk, lenders assess the borrowers’ credit ratings
and use these ratings as a basis for charging interest rate. If there is a higher level of perceived
credit risk, investors or lenders demand a higher rate of interest. Credit risk and interest rates are
further discussed in this module.

Module Objective
After successful completion of this module, you should be able to:

• Describe different theories in setting cost of financing

• Identify different factors affecting interest rates
• Describe different ways on how to mitigate credit risks

Course Materials
Credit risk and Interest Rates

Credit risk
Credit risk is defined as the risk that the value of a loan (or more generally, a stream of debt
payments) will decrease due to a change in the borrower’s ability to make payments, whether that
change is an actual default or a change in the borrower’s probability of default. Thus, it affects the
value of the financial instruments.

Example:
• A consumer may fail to make payment due on a mortgage loan, credit card or any other
loan
• An insolvent insurance company does not pay a policy obligation

Interest rates
Interest rate is the amount a lender charges for the use of assets expressed as a percentage of
the principal. This is set to compensate the risk of allowing the finances to flow into the financial
system.

For lenders - lending rate of return

For the borrowers – cost of debt

THEORIES RELATED IN SETTING INTEREST RATES

• Economic theories that drives the interest rates ( Fabozzi and Drake)
o Loanable funds theory – introduced by Knut Wicksell in 1900s. This theory
assumes that it is ideal to supply funds when the interests are high and vice versa.
This theory further states that interest rates will be determined by the supply and
demand for funds. If people save more, there will be more funds for investment, this
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POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

will reduce interest rates. If demand for borrowing increases, this will push up the cost
of borrowing.
o Liquidity preference theory – introduced by John Maynard Keynes. This theory
assumes that the interest rates are dependent on the preference of the household
whether they hold or use it for investment. Thereby, the longer the term the higher the
rates because investors preferred the short-term investment more.
Watch:
• Loanable Funds Definition Theory
( https://www.youtube.com/watch?v=34J8aH_rn04 )
• What is LIQUIDITY PREFERENCE? What does LIQUIDITY PREFERENCE
mean? LIQUIDITY PREFERENCE meaning
( https://www.youtube.com/watch?v=a43RSkWBvss )

• Economic theories that affect the term structure of interest rate.

Term structure of interest rates is the relationship between interest rates or bond
yields and different terms or maturities
o Expectation theories - interest rates are driven by the expectation of the lenders or
borrowers in the risks of the market in the future.
Pure expectation theory – based on the current data and statistical analysis to
project the behavior of the market in the future. They all rely on the forward rates or
the future interest rates based on their projection on the future prices.
Biased expectation theory – includes that there are other factors that affect the
term structure of the loans as well as the interest to be perceived moving forward.
The forward rates will be affected or will be adjusted if the liquidity of the borrower
will weaker or stronger in the future.
✓ Liquidity theory – Liquidity premium increases as the maturity lengthens.
Liquidity premium – the adjustment or increase on the interest rate
✓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. The habitat being referred here is the biased estimate over
the market behavior in the future.
o 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.
Watch:
• Term Structure of Interest rates
( https://www.youtube.com/watch?v=krHCxTHard0 )

DETERMINATION OF INTEREST RATES

Three factors to be considered to determine the appropriate interest rates:
• Interest rates in the industry
• Risk exposure
• Compensation on the market expectation
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POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

Interest rate can be calculated:

• By the function of the risk (such as default risk and contractual provision) and the
compensation of the investor on the difference between the risk-free rate and the market
fluctuation
i = Rf + Dm
Formula:
Where: i = interest
Rf = risk free rate ( real risk-free rate + inflation expectation premium )
Dm = debt margin or debt spread or the risk premium

o Risk free rate (Rf) - should the rate that assumes zero default in the market
where there is more or less equivalent to the rate offered by the sovereign.
Normal basis is the Treasury bill issued by the republic.
Can be:
Real = excludes the effect of inflation or the exclusion of the effect
of the purchasing power of Philippine Peso.
(Nominal risk free rate (Rf) – prevailing or current inflation)
Nominal (actual) Rf = risk free adjusted for inflation
o Debt margin/risk premium (Dm) – consists of a number of issuer and issue-
related components, including interest rate risk, liquidity risk, tax risk, default
risk, maturity risk and contractual provision risk.
It causes similar – maturity securities to have differing nominal rate
of interest.
Example 1:
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?
Given:
6% = nominal risk free rate
2% = prevailing or current inflation
3% = expected inflation
4% = debt margin
Using the formula:
i = Rf + Dm

Real risk free rate + expected

= +
inflation 4%
(Nominal risk free rate - current
= +
inflation) + expected inflation 4%
= (6% - 2%) + 3% + 4%

= +
4% + 3% 4%
=
11%
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POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

Example 2:
The real rate of interest is currently 3%; the inflation expectation and risk premiums for
Security A is 6% and 3%, respectively. What is the nominal rate of interest for Security A?
Given:
3% = real risk free rate
6% = expected inflation
3% = risk premium
Using the formula:
i = Rf + Dm

= +
Real risk free rate + expected inflation 3%
= +
3% + 6% 3%
= +
9% 3%
=
12%

• By the function of the market value, par value and the interest expense paid by debt
securities or bonds.
Formula:
V- M
I + ( )
n
i= x 100%
V+ M
2
where:
i= interest rate
I = periodic interest payments
V=par value of bonds
M=market value of bonds
n=term of bonds
Example 1:
Merlin Corporation issued bonds with 10% nominal rate of 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 Merlin bonds in the market?
Given:
10% - Nominal interest rate
P1,000 – par value
P1,200 – market value
20 years – term of bonds
Using the formula:
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POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

V - M
I + ( )
n
i = x 100%
V + M
2
1000 - 1200
(1000 x 10%) + ( )
20
= x 100%
1000 + 1200
2
100 + -10
100%
= 1100 x
90
=
1100 x 100%
= 8.18%

Example 2:
The Salem Company bond currently sells for P955, has a 12% coupon interest rate and a
P1,000 par value, pays interest annually, and has 15 years to maturity. How much is the
interest rate of the Salem bonds in the market?
Given:
12% - Nominal interest rate
P1,000 – par value
P955– market value
15 years – term of bonds
Using the formula:
V - M
I + ( )
n
i = x 100%
V + M
2
1000 - 955
(1000 x 12%) + ( )
15
= x 100%
1000 + 955
2
120 + 3
100%
= 977.5 x
123
=
977.5 x 100%
= 12.58%

Risk that are inherent in every financing transaction:

• Default risk – arise on the inability to make payment consistently
• Liquidity risk – identified by ensuring the business to be capable of meeting all its currently
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POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

maturing obligation. It is focusing on the entire liquidity of the company or its ability to service
its current portion of their debt as it comes due.
• Legal risk – is dependent on the covenants set and agreed in between the lenders and the
borrowers.
• 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.

MITIGATING THE INTEREST RATE RISKS

• Spot rate – the interest rate or yield available / applicable for a particular time. It is based
on the prevailing market rate at the particular time. Spot rates will be used to mitigate the
risk by referring to historical yield vis a vis the forces that occur in those time. 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 viability of rates will be managed.
• 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 rates – another contracted rate where a fixed rate exchange for a certain market rate
at a certain maturity, usually the one used as reference is the LIBOR. LIBOR or London
Interbank Offered Rate is used to benchmark interest rates which is used as reference for
international banks to borrow. It is calculated using the Intercontinental Exchange or ICE.

CREDIT RATING
Credit rating is a quantified assessment of the creditworthiness of a borrower in general terms or
with respect to a particular debt or financial obligation. It is another driver of the interest rate or
risk consideration aside from the purchasing power and other factors. The credit ratings are
assigned to the companies based on their riskiness, primarily driven by their ability to manage
their liquidity and solvency in the long run. Credit ratings are just recommendatory opinion, serve
as reference only and is not an absolutely provide default probability to the companies.

Three major rating companies:

• Standard & Poor’s Corporation (S&P)
An American financial services corporation was founded in 1941 by Henry Varnum Poor
in New York, USA. The company uses data gathering from 128 countries using more than
1,500 credit analysts to assess the creditworthiness to the industry.
S&P Credit rating table:
AAA Extremely strong capacity to meet financial commitments
Grade
Investment

AA Very strong capacity to meet financial commitments

A Strong capacity to meet financial commitments but susceptible to adverse economic conditions
and changes in circumstances
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,
Speculative Grade

financial and economic conditions

B 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
CC Highly vulnerable, default has not yet occurred, but expected to be a virtual certainty
C Currently highly vulnerable to non-payment, and ultimately recovery is expected to be lower
than that of higher related obligations
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Office of the Vice President for Branches and Satellite Campuses
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D 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 Services

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.
Mood’s rating scale:
Aaa Obligations rated Aaa are judged to be of the highest quality, subject to the lowest level of credit risk
Aa Obligations rated Aa are judged to be of high quality and are subject to be very low credit risk
A 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
B 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
Ca Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospects of
recovery of principal and interest
C Obligations rated C are the lowest rated and are typically in default, with little prospect for recovery of
principal or interest
• Fitch ratings
It was founded in 1914 in New York USA. It was owned by Hearst, 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.
Fitch rating scale:
AAA Highest credit quality
AA Very high credit quality
A High credit quality
BBB Good credit quality
BB Speculative
B Highly speculative
CCC Substantially credit risk
CC Very high levels of credit risk
C Near default
D Default
• Other rating agencies
o DBRS – established in 1976 in Toronto, Canada. The company was considered as
the fourth largest rating agency.
o CARE Ratings – started its operation in 1993 and based in India. The company is
based in Mumbai with partners in Brazil, Portugal, Malaysia and South Africa.
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POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

Activities / Assessments

1. What is the term structure of interest rates, and how it is related to the yield curve?

2. Briefly describe the following theories of the general shape of the yield curve:
a) Expectations theory b) Liquidity preference theory c) market segmentation theory

3. What is the real rate of interest? Differentiate it from the nominal rate of interest.

4. Elliot Enterprises’ bonds currently sell for P1,150, have an 11% coupon interest rate and
a P1,000 par value, pay interest annually, and have 18 years to maturity. How much is the
interest rate of the Elliot’s bond in the market?

5. ABC Company would like to borrow from XYZ Financing. The risk-free rate is 8% and the
current inflation is 3%. The inflation is expected to grow to 4% in the following year. ZYX
finds that the 3% margin remains to be relevant. How much is the interest rate that XYZ
should impose to ABC?

E5-1 True or False (page 138-141)