Solutions for End-of-Chapter Questions and Problems: Chapter Sixteen
1. What risks are incurred when making loans to borrowers based in foreign countries? Explain.
When making loans to borrowers in foreign countries, two risks need to be considered. First, the credit risk of the project needs to be examined to determine the ability of the borrower to repay the money. This analysis is based strictly on the economic viability of the project and is similar in all countries. Second, unlike domestic loans, creditors are exposed to sovereign risk. Sovereign risk is defined as the uncertainty associated with the likelihood that the host government may not make ...view middle of the document...
Even though bondholders usually appoint trustees to look after their interests, it has proven to be much more difficult to approve renegotiation agreements with bondholders in contrast to bank syndicates.
b) The group of banks that dominate lending in international markets is limited and hence able to form a cohesive group. This enables them to act in a unified manner against potential defaults by countries.
c) Many international loans, especially those made in the post-war period, contain cross-default clauses, which make the cost of default very expensive to borrowers. Defaulting on a loan would trigger default clauses on all loans with such clauses, preventing borrowers from selectively defaulting on a few loans.
d) In the case of post-war loans, governments were reluctant to allow banks to fail. This meant that they would also be actively involved in the rescheduling process by either directly providing subsidies to prevent repudiations or providing incentives to international agencies like the IMF and World Bank to provide other forms of grants and aid.
4. What two country risk assessment models are available to investors? How is each model compiled?
The Euromoney Index was originally published as the spread of the Euromarket interest rate for a particular country’s debt over LIBOR. The index was adjusted for volume and maturity. The index recently has been replaced by a large number of subjectively determined economic and political factors.
The Institutional Investor Index is based on surveys of the loan officers of major multinational banks who subjectively give estimates of the credit quality of given countries. The scores range from 0 for certain default to 100 for no probability of default.
5. What types of variables normally are used in a CRA Z-score model? Define the following ratios, and explain how each is interpreted in assessing the probability of rescheduling.
The models typically use micro- and macroeconomic variables that are considered important in explaining the probability of a country’s credit rescheduling.
a. Debt service ratio. The debt service ratio (DSR) divides interest plus amortization on debt by exports. Because interest and debt payments normally are paid in hard currencies generated by exports, a larger ratio is interpreted as a positive signal of a pending debt rescheduling possibility.
b. Import ratio. The import ratio (IR) divides total imports by total foreign exchange reserves. A growing amount of imports relative to FX reserves indicates a greater probability of credit restructuring. This ratio is positively related to debt rescheduling.
c. Investment ratio. The investment ratio (INVR) measures the investment in real or productive assets relative to gross national productive. A larger investment ratio is considered a signal that the country will be less likely to require rescheduling in the future because of increased productivity; thus...