Credit Quality and Interest Rate

Summary of chapter 8

Prepared by Jinwen Hu

Student number: 7836363

Every company is sensitively impacted by the changes in interest rate. Since there are various kinds of circulated currency all over the world, it is necessary to know the structure of interest rate and how the firm operates under the impact of constant changing interest rate.

        There are different reference rates and floating rates exist in the market such as USD-LIBOR, PIBOR, MIBOR etc. Since interest rates are currency specific, the interest rates will volatile depending on the kind of currency it is.

        Credit quality – indicates how well individual borrower can repay their debt on time. Borrower such as governments or companies are entitled to that. In addition, when individual borrowers are paying different rate to borrow, they also have access to certain amount of capital or debt. Depending on the credit quality of the individual borrower, they will have different cost of capital which is equal to risk-free rate of interest plus credit risk premium. Credit risk premium credit risk of the specific individual borrower. And the borrower’s credit rating is decided by credit rating agencies, for example Moody’s, Standard & Poors, and Fitch. Since cost of debt correlates with credit quality, higher the rating, lower the cost of debt rate

        Credit risk, which indicates a borrower’s creditworthiness at the time of renewing a credit. However, repricing risk shows the risk of interest rate changes at the time a financial contract’s rate is reset. For most of multinational enterprises, for non-financial firms, the largest interest rate risk is debt services, follows by their interest-sensitive securities (liabilities) as well as their borrowing or investment.

        To manage the interest rate risk with any loan agreement, company can select from the following alternative: refinancing, forward rate agreements, interest rate futures or interest rate swaps. For interest rate futures, it’s simple to use thus wide accepted. Two most widely used futures contracts are CME and CBOT. If interest rates rise the futures prices will fall and vice versa.  In situation such as forward rate agreement, buyer of the agreement can lock the rate at a desired term that starts at a future data. If the interest rate is higher than the agreed rate at the future date, seller if FRA will pay buyer the increased amount, buyer will pay for the different if the rate falls below the agree term. Interest rate swaps usually happen between a firm and a swap dealer. It contains interest rate swap, currency swap and the combination of both. Lastly, firms can swap cross currency because of the fixed to floating rate interest rate swap in each currency (typical currency such as USD, Japanese yen and Swiss Franc.