LECTURE 4-5: INTERNATIONAL PARITY CONDITIONS

What is an interest “reference rate” and how is it used to set rates for individual borrowers?
A reference rate – for example, U.S. dollar LIBOR – is the rate of interest used in standardized quotation, loan agreement or financial derivative
valuation. LIBOR, in London Interbank Offered Rate, is by far the most widely used and quoted reference rate.

Why has LIBOR played such a central role in international business and financial contracts? Why has this been questioned in recent debates
over its value reported?
LIBOR is quoted for overnight, 1 week, 1 month, 2 months, etc. through 12-month maturities. Of these, 1-month, 2-month and 6-month LIBOR
are the most significant maturities due to their widespread use in various loan and derivative agreements. Each day, a panel of 16 major
multinational banks is requested to submit estimated borrowing rates in the unsecured interbank market. One problem with LIBOR is the origin
of the rates submitted to banks. They are based on “Estimated borrowing rates” to avoid reporting only actual transactions. As a result, the
origin of the rate submitted becomes, to some degree, discretionary. Furthermore, banks have a number of interests that may be impacted by
borrowing costs reported on that day.

What is a credit risk premium?

Individual borrowers – whether they are governments or companies – possess their own individual credit quality, the market’s assessment of
their ability to repay debt in a timely manner. The cost of debt for any individual borrower will therefore possess two components, the risk-free
rate of interest plus a credit risk premium reflecting the assessed credit quality of the individual borrower. The credit risk premium represents
the credit risk of the individual borrower. In credit markets this assignment is typically based on the borrower’s credit rating as designated by
one of the major credit rating agencies. It is based on the industry in which the firm operates, its current level of indebtedness, its past, present
and prospective operating performance, and a magnitude of other factors.

What is a credit spread? What credit rating changes have the most profound impact on the credit spread paid by corporate borrowers?
The costs of credit quality – credit spreads – are quite minor for borrowers of investment grade. Speculative grade borrowers, however, are
charged a hefty premium in the market. It reflects the difference in yield between a treasury bond and another debt security of the same
maturity but different credit quality. Cost of debt can change due to the credit quality or the maturity.

What do the general categories of investment grade and speculative grade represent?
Although there is obviously a wide spectrum of credit ratings, the designation of investment grade versus speculative grade is extremely
important. An investment grade borrower (Baa3, BBB-, and above) is considered a high-quality borrower that is expected to be able to repay a
new debt obligation in a timely manner regardless of market events or business performance. A speculative grade borrower (Ba1, or BB+ and
below) is believed to be a riskier borrower and depending on the nature of a market downturn or business shock, may have difficult servicing
new debt.

What is sovereign debt? What specific characteristic of sovereign debt constitutes the greatest risk to a sovereign issuer.
Debt issued by governments – sovereign debt – is historically considered debt of the highest quality, higher than that of non-government
borrowers within that same country. This quality preference stems from the ability of a government to tax its people and, if need be, print
more money. Although the first may cause significant economic harm in the form of unemployment, and the second significant financial harm
in the form of inflation, they are both tools available to the sovereign. The government therefore hast the ability to service its own debt, one
way or another, when that debt is denominated in its own currency. The most important risk in sovereign debt is the risk of default by the
issuing country. For this reason, countries with stable economies and political systems are considered to be less of a default risk in comparison
to countries with a history of instability.

Why do borrowers of lower credit quality often find their access limited to floating-rate loans?
Credit ratings, in general, attempt to establish whether a firm can meet it debt-service obligations under worsening economic conditions, firms
that are highly credit worth may view fixed rates as more relevant than firms that are of lower quality/speculative grades.

What is an interest rate future? How can they be used to reduce interest rate risk by a borrower?
Interest rate futures are relatively widely used by financial managers and treasurers of nonfinancial companies. They are popular because of
the high liquidity of the interest rate futures markets, their simplicity in use, and the rather standardized interest rate exposures more firms
possess.

What would be the preferred strategy for a borrower paying interest on a future date if he expected interest rates to rise?
They would want to pay fixed so they can lock in the lower interest rate. The borrower, after reviewing current market conditions and forming
expectations about the future, may conclude that interest rates are about to rise. In order to protect the firm against rising debt-service
payments, the company’s treasury may enter into a swap agreement to pay fixed/receive floating. This means that the firm will not make fixed
interest rate payments and receive from the swap counterparty floating interest rate payments.

What is a plain-vanilla interest rate swap? Are swaps a significant source of capital for multinational firms?
If the agreement is for one party to swap its fixed interest rate payment for the floating interest rate payments of another, it is termed an
interest rate swap, sometimes referred to as a plain vanilla swap.