Sovereign Rating News And Financial Markets -Myassignmenthelp.Com

Question: Discuss About The Sovereign Rating News And Financial Markets? Answer: Introduction The domain of corporate finance is defined by analysing returns for various classes of assets and understanding their risk rates. Investors invests into assets classes in order to maximize their returns and minimize their risks associated with certain classes of assets(Boubakri, 2011). Asset classes might be debt or equity that can be domestic or international. In case investors wishes to diversify across several classes of investments he might wish to select a portfolio mixture of debt and equity and in cases he wishes to diversify across countries, he might select global portfolios. The scope of the current analysis concerns examining strategy of international diversifications. Most investors wishes to m minimize risks and maximize returns. In order to maximize returns, international diversification is often selected. Strategy involved in diversifying across international markets includes analysing rate of returns, macroeconomic factors, risk free rate of return and also taking int o consideration currency rate fluctuations. Capital Asset Pricing Model (CAPM) helps calculate return from risks calculations and risk free rate. However, it takes into consideration domestic assets classes. To broaden financial analysis ICAPM (International Capital Asset Pricing Model) is taken into consideration that takes into account currency rates and also links returns to consumption patterns(Fama, 2014). In the second part of discussion CAPM is contrasted with ICAPM, in order to understand their distinctions. Their individual limitations are also discussed for gaining greater insights into them. Sovereign debt is a national debt which is rated by SPs for benchmarking. SPs while analysing sovereign debts takes into consideration various factors that includes payback capacity of the government, past payments, risk factors and so on. In the end certain conclusion for overall understanding drawn from ICAPM, CAPM and sovereign debt is drawn. Examine the strategy of international diversification and the application of ICAPM Strategy of international diversification is based on the theory that global portfolios earns higher returns compared to domestic only portfolios. Historically, there has been a preference of globally diversified portfolio as against domestic-only portfolios on the efficiency aspect. Global portfolios are capable to generate higher levels of returns for same levels of risks and often take lesser risks for same levels of returns(Dean, 2011). There remains investors anxiousness regarding international investments as a result of poor performance outside of US in the last year. Gerstein Fisher long-term belief is focused on globally diversified portfolio. There are no appropriate tools for predicting a single market that has capability to consistently perform amongst top global stock markets. As a single market cannot be predicted, diversifying across a large number of countries can allow gaining high returns. Global market diversifications provided multiple benefits from their reactions to domestic monetary and fiscal policy cycles that has been found to be beneficial when combined with US investments. Performance cannot be held as the only argument for purpose of international investments. Diversification can lead to benefits from investing in low cross-correlation countries that can contribute towards reducing volatility for the total portfolio for long-term period(Lai, 2009). Global diversification allows diversifying risks-adjusted returns for portfolio performances. a fixed strategic percentage of global investments internationally can allow significant benefits. Application of ICAPM (International Capital Asset Pricing Model) is consumption oriented asset pricing model that delivers returns expected from a security. ICAPM was introduced by Sharpe (1964) and Lintner (1965) and extended by black (1972) as an extension to CAPM model that takes into consideration time-varying factors. The underlying assumption in this theory is that investors will hedge their position of risks based on future returns, unemployment rates, inflation and so on. In this type of portfolio, primary investment that is lined to the market is also hedge for mitigation of risk perceived. Hedging portfolios will be separate based on risk factor of investors(Maio, 2012). The model uses mean-variance analysis for arriving at normal distribution for risk consumption for a period of time. As it covers a number of periods it includes multiple beta coefficient for varied portfolios. Expected return taking into account global factors for calculation of ICAPM is; Applying ICAPM in international market can provide that the market is integrated. In case market is segmented,(Arouri, 2009) then discrepancies in asset prices of same risk profiles results from varied currencies that are used. The above factor of often leads to inefficient type of asset pricing hence ICAPM can be applied for selection of optimal portfolios by analysing impact from currency movements on asset prices that has same risk profiles in varied countries. Thus, it can be said that ICAPM can easily be applied for global portfolios where investor aim at diversifying stock returns for varied risk profiles. Compare and contrast ICAPM and with domestic CAPM and critically evaluate the limiting assumptions of these models Answer: Investment in any asset class involves substantial amounts of risks that can be minimized by way of financial tools by analysing expected returns. The CAPM and ICAPM are financial tools that helps arrive at expected returns associated with a particular class of assets. CAPM takes into account required rate of return on an asset, risk-free rate along with the assets sensitivity to the market(Cochrane, 2009). These financial tools and models are defined with certain underlying assumptions as absence of taxes, no transaction costs, investors can easily obtain risk-free rate of lending and investors are risk averse in nature. These underlying assumptions cannot be fully be accepted into real world setting hence CAPM and ICAPM is regarded as tools for calculating expected returns on certain class of investments. ICAPM is often considered to be more useful as compared to CAPM in general practice, however ICAPM also has certain limitations on its practicality. From calculations of r eturns, it can easily be said that investors want to be compensated for their time value of money which is obviously more than the risk free rate of return. As investing into market requires bearing of considerable risks, investors requires certain amount of premium to be paid over the risk free rate of return in the market(Bali, 2009). ICAPM is an expanded form of CAPM model that allows for investors getting premium for bearing risks and be paid for being exposed directly or indirectly to foreign currency. ICAPM integrates currency effects into CAPM considerations when investors holds an asset especially in foreign portfolio. Further sensitivity to foreign currency provides additional profitability impacts either directly or in an indirect manner. CAPM and ICAPM provide methods that allow calculations of returns over risk free rates or rates of interests. Domestic CAPM incorporates that investors are investing into specific asset class where they reside. This model assumes that domestic investor does not have access to opportunities in international markets for the purpose of diversification of risks. In this model capital markets of countries are assumed to be separated from each other and segmented as per international perspective. As per this perspective beta is a measure of the countrys market index, which is the equity premium delivered at local market premium(Elbannan, 2014). The model has applicability in the real practical world but does not take into consideration currency rates. ICAPM on the other hand enables market investors in the global forum. It encompasses diversification of portfolio by earning a diversified rate of return according to its risk factors. Similarities of CAPM and ICAPM is that both the models as sumes investors being risk averse in nature having uniform expectation of returns and risks from all asset classes. These models also assumes that investors holds some combinations of risk-free assets and market portfolio(Khan, 2008). Differences of these models are in their market portfolio that constitutes them, while domestic CAPM comprises of all domestic equity assets. ICAPM includes globally diversified risky asset classes. CAPM does not include any hedging options, whereas ICAPM includes currency hedging or a hedging portfolio to overcome risk associated with particular asset class investments. ICAPM is particularly useful in cases of portfolio management and stock selection while undertaking assumptions. These models can highly influence selection and designing of portfolio for investors for selecting amongst two assets classes across varied countries. ICAPM can be used along with other financial tools allowing investors to select assets that will meet their expectations on required rate of return(Dempsey, 2013). However, ICAPM assumes that global markets are integrated and efficient, in case this assumptions does not apply then allocating stocks selection can result in currency advantage that can result in alpha. Limiting assumptions of these models encompasses that CAPM includes asset classes from domestic markets only. Whereas limiting conditions for ICAPM is that it considers international classes of investments. An evaluation of whether to invest the entire foreign bond allocation in euro-denominated bonds or reallocate the money to US bonds over the next year From above returns calculated on Euro Denominated bond and looking at 1 Year forward rate it can be concluded that it is best to invest in it. Euro Denominated Bonds will generate better returns compared to USD denominated Bonds. As 1 Year forward outlook for Euro Exchange Rate is $1.5 per euro, it is advisable to remain invested into Euro Bonds rather than diverting into US Bonds. Interest rate of US bond is low hence investor will benefit from higher rate of interests as well as higher currency exchange rate. Show your calculation of the US dollar return on the euro- denominated bonds A fixed-for-floating swap is contractual agreement between two parties, where one party swaps interest rate for cash flows for a fixed loan with a floating rate loan of another party. The principal of the loan is not exchanged. This type of arrangement can highly reduce interest expense by swapping for a fixed rate of interest that is lower than fixed rate that is paid currently. Manufacturing company as ABC Limited making motor components taken a floating-rate loan from bank. The company wants to swap it for fixed-interest rate exposure from one-year quarterly-paying pension fund at 6%. The floating rate for 360-day year interest is LIBOR + 1%, where annual LIBOR rates are available for quarter 1 being 5.5%, quarter 2 being 5.4%, quarter 3 being 5.8% and quarter 4 being at 6.0%. Fixed rate interest swap is desirable for a company like ABC Limited as interest rate predictions in the future might rise. It can enable the company to better match liabilities and assets which are sensitive to interest rate movements. It also helps to diversify total loan portfolio by exchanging interest rates. It is generally performed with the expectation that interest rates in the market is expected to rise. With volatility in interest rate market, it might be best suited that the company uses hedging option and opts for fixed rate of interest as in case of rise in interest rate, there might more payments incurred by the company. Hedging for fixed rate of interest rate would also allow to prevent uncertain cash flows in the future. The company can easily access its cash flows for future period, which might otherwise would have been impossible in cases of floating rates of interests. Show your calculations of the quarterly swap payments due from ABC Limited for the duration of the swap agreement and comment on alternative hedging possibilities which open to the company. (20 marks) Answer: ABC Company had a notional amount of GBP2, 000,000, which was swap for fixed interest payment with TrustInvest Corp. TrustInvest Corp on the other hand decided to pay a LIBOR+1% rate for the amount. Discounting factor for arriving at cash flows have been calculated in Appendix 2. This is the annual payment SWAP rate that has to be paid quarterly at 1.86% annually. Quarterly SWAP payment is 9300 for a period of 1 year during the swap agreement. Total SWAP payments is GBP 37200 which is highly profitable for the Company. Alternative possible hedging possibility in rising interest rate market is to have lower rate of floating rate discounted to LIBOR. ABC Company can easily hedge with currency rate swaps that offers strategy to overcome current positions. Currency hedges are done on a continuous basis by investors, bankers, portfolio managers and retail investors. Hedging with currency exchange rates can allow potential changes to be made in one currency against the other and can be used for overcoming interest rate risks. However, there are no notional principals present in currency swaps to hedge against possibility of risk exposure. It can be done to achieve better rates of lending and hedge against any possible interest rate fluctuations. Consider the following statement: The debt of national governments sovereign debt - is rated by nationally recognised statistical rating organisations such as Standard and Poors (SP). With referenced to the above statement, explain what you understand by sovereign debt and critically discuss the key factors you would expect to be used by rating agencies, such as SP, for sovereign debt ratings. Answer: A Sovereign Debt is also known as a government debt, public debt or national debt and is a central governmental debt. Government of a country issues Sovereign Debt in foreign currency for financing of a countrys development and growth(White, 2010). A countrys Sovereign Debt ratings provides stability of the issuing government that allows investors to weigh risks while analysing sovereign debt investments. Sovereign Debt is rated by nationally recognized statistical rating organization as Standard and Poors (SP). This type of debt can be external or internal in nature, in case categorised as internal debt then it is owed to lenders within the country. In case sovereign debt is classified as external debt then it is owed to foreign lenders. Sovereign Debt is classified by the duration of the debt until its repayment is due. In cases of short-term classified debt, it is usually less than a year(Candelon, 2011). If debt is classified as long term debt, then it can last for more t han 10 year duration. Sovereign debt is issued by governments by giving out bills, bonds or by issuing of securities. Some sovereign bonds borrow directly from world organizations as World Bank and other international financial organizations. Sovereign bonds involves small amounts of lending risks, default risks and in the countrys own currency it is the risk-free rate of investment. Sovereign credit rating is the credit rating of a country or of the sovereign entity. Rating of sovereign bonds provides investors insights into level of risks associated with investment to be made in a particular country which encompasses political risks. Rating agencies evaluates the countrys political and economic environment for arriving at a credit rating. For developing countries, it becomes essential to arrive at good sovereign ratings for having an access to international bond markets. SPs issues credit ratings for sovereign bonds, which are essential as it allows the country access to foreign markets for the purpose of attracting direct foreign investments. Standards and Poors provides a solid rating that demonstrate transparent and countrys standing position. SP provide BBB- or higher credit ratings for sovereign bonds that are investment grade belwo which they do not consider worth investing. Key factor SP considers while rating a countrys sovereign bonds apart from its political and economic conditions are its risk portion that defines a governments capability to meet debt obligations. Some other factors that rating agencies considers are debt service ratio, import ratio, growth I n domestic supply, variance of export revenue and so on. Conclusions Analysing above trends in capital asset pricing models it can said that investors need to diversify their portfolio with global assets. Calculating returns on assets on global portfolio is suitable by way of ICAPM model. Investors evaluate performance of their asset classes by evaluating their portfolio as per CAPM model in case of domestic markets and ICAPM model when evaluating globally diversified portfolios. In each situation these models plays an active role to determine and understand risk appetite associated with an investor. While investing in debt market with currency hedge, an investor is more likely to select a higher interest paying market compared to a lower interest paying market. Especially in case where 1 Year forward rate is expected to rise against the other currency. Interest rate swap is an option that is selected by company in case of predicting an interests rate rise to hedge situation. Often a fixed rate of interest is hedged against floating rate of interest or floating rate of interest against fixed rate. LIBOR acts as the benchmark for interest rates against which companies or investors calculates their position. Sovereign Debt is a national debt, which is rated by SP index. This index uses various parameters for judging sovereign ratings of bonds. A sovereign bond is usually evaluated such as to attract suitable number of investors into purchase of bonds. SP makes use of various pertinent criteria such that appropriate rating for sovereign bonds can easily be arrived at. It reflects a governments capability or willingness to repay back loans and debts of the country. Reference Lists Arouri, M. E. (2009). Are stock markets integrated? Evidence from a partially segmented ICAPM with asymmetric effects. arXiv preprint arXiv:0905.3875. Bali, T. . (2009). A cross-sectional investigation of the conditional ICAPM. In URL: https://www. bus. wisc. edu/finance/workshops/documents/Bali-Engle. pdf. Boubakri, S. . (2011). Financial integration and currency risk premium in CEECs: Evidence from the ICAPM. Emerging Markets Review, 12(4), 460-484. Candelon, B. S. (2011). Sovereign rating news and financial markets spillovers: Evidence from the European debt crisis (No. 11-68). International Monetary Fund. Cochrane, J. H. (2009). Asset Pricing:(Revised Edition). Princeton university press. Dean, W. G. (2011). Feedback trading and the behavioural ICAPM: multivariate evidence across international equity and bond markets. Applied Financial Economics, 21(22), 1665-1678. Dempsey, M. (2013). The capital asset pricing model (CAPM): the history of a failed revolutionary idea in finance? Abacus, 49(S1), 7-23. Elbannan, M. A. (2014). The capital asset pricing model: an overview of the theory. International Journal of Economics and Finance, 7(1), 216. Fama, E. F. (2014). Two pillars of asset pricing. American Economic Review, 104(6), 1467-85. Khan, M. (2008). Are accruals mispriced? Evidence from tests of an International capital asset pricing model. Journal of Accounting and Economics, 45(1), 55-77. Lai, L. H. (2009). Underwriting systematic risk and profit margin in fuzzy CAPM and ICAPM models: the case of aviation coverage. Contemporary Management Research, 5(4). Maio, P. .-C. (2012). Multifactor models and their consistency with the ICAPM. Journal of Financial Economics, 106(3), 586-613. White, L. J. (2010). Markets: The credit rating agencies. Journal of Economic Perspectives, 24(2), 211-26.