- Foreign exchange rate risk
This risk happens when the investor is trading an SFP whose underlying effect is not denominated in the host country. Currency fluctuations that negatively impact the underlying asset value and the price of the structured product (Basanna & Vittala 2019, p.93). Although Australia’s flexible exchange rate has had an impact on macroeconomic stability, individual benefits from the exchange rate depends on how they are exposed to currency movements (Reserve Bank of Australia 2017).
As an Australian investor, therefore, the client may face exchange rate risk due to currency fluctuations. The Australian dollar is generally a risk-on currency because the country’s economy relies heavily on commodity prices and global growth. If the client’s liabilities, for example, are large and in foreign currency, a sharp exchange rate depreciation will negatively impact the client’s cash flow.
- Interest rate risk
Refers to investment loss possibility due to fluctuations in interest rate. The risk result from changes in interest rates, increase or decrease in interest rates (Fusai, Longo & Zanoti 2021). Compared to other financial institutions in the world, the financial institutions in Australia experience low exposure to risks. Policy-makers and customers often bear the interest rate risk.
Institutions use a model of operation that encourages the yield curve to continue moving upwards by controlling the rise of interest rates (Reserve Bank of Australia 2018). If this situation remains, the client may also be free from interest rate risk. However, if the interest rates begin to rise, making the yield curve flat, the trade’s net interest margin will shrink. This will expose the client and the issuer (bank) to interest rate risk.
- Issuer default risk
Defines situations where an investor termed unsecured creditor, having lost claims over assets that the issuer holds (Pestler & Schertler 2019, p.343). It happens due to insolvency of issuer of SFP and defaults on the issuer’s listed securities. Generally, SFP faces a high risk of issuer’s failure to repay the investor’s money. It may also happen when the issuer stops providing interest payments. The client will most likely face this risk if the issuer closes business.
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How to assess the credit risk of this SFP
Credit risk assessment process utilises both qualitative and quantitative approaches. Qualitative credit risk assessment methods focus on market potential assessment conducted by staff and information on compliance of management (Soares, Pina, Ribeiro, & Catalao-Lopes, 2011). Credit risk qualitative assessment involves search for information on current debt, debt type, debt duration, payment interest, and payment history.
On the other hand, quantitative analysis of credit risk involves evaluation of the concerned company’s financial statement and other relevant financial indicators. The quantitative credit risk assessment makes use of actual numbers. The examples of qualitative and quantitative credit risk assessment are discussed below:
1. Quantitative Credit Risk Assessment
The methods include financial analysis and calculation of expected return on loan.
· Using implications of loan pricing to calculate expected Return on Loan
To formulate the correct loan pricing strategy, costs, profit and risks have to be considered. To derive costs of funds, it is important to determine the interest expense of the company. Additional costs include capital costs, overhead costs, fixed costs, and variable costs. For risks, a risk premium should be included in the pricing structure.
Lastly, actual profit is indicated by a margin that exceeds the costs and risk. Key variables here include base lending, fees, risk premium, costs due to reserve requirements, and compensatory balances (Papin 2013). These variables and industry data can be collected from reputable websites.
Calculation of expected return on loan
Expected return refers to profit or loss anticipated by an investor. Important variables include: probability of repayment and chances of default (Papin 2013). The results will reveal if the average net outcome of an investment is either positive or negative. The formula is as follows:
1+k = 1+(f +(BR+O))/1-[b(1-RR)] E(r) = p(1+k)
Where:
BR – is the base lending rate, reflects funds cost O - risk premium
f – fees b – compensating balance RR – reserve required imposed cost
When setting risk premium, it is important to ensure that it accounts for p. In other words, there should be a strong connection between these variables. Rates, security, compensating balance, and fees are capable of increasing the promised gross return. For instance, increasing fees, compensating balance and setting a higher margin risk premium will increase k in spite of a lower p.
· Credit Risk Assessment: Merton Model
Merton Model uses a corporate’s balance sheet to determine probability of defaults. It majorly focuses on assets (At) and liabilities (debts (Dt) and equity (Et)). The model assumes that a company defaults if its debt value exceeds the value of its assets, that is AT<DT (Lütkebohmert 2009, p.22).
When this happens, the company’s owner achieves no returns, leaving value of equity at zero (ET = 0). The owner, thus, loses all the capital and will not pay the creditor. On the other hand, if the assets’ real value happens to be greater than value of debt (AT>DT), at the time (T), the entire debt is paid. The value of equity will be the difference between values of assets and debt (ET=AT-DT).
Merton Model also assumes that AT goes according to geometric Brownian Motion (Lütkebohmert 2009, p.23). That is:
dAt= μAAt + σAAtdwt
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2. Qualitative Credit Risk Analysis
Moody’s rating analysis is the qualitative credit risk analysis method in this discussion.
Moody’s rating analysis
Written information and personal observation are necessary in the ratings process. Therefore, the information on the company’s financial statement as well as those from reputable websites like Yahoo Finance are important. In Moody’s rating analysis, the important details about the issuer include issue and company structure, operating financial status, quality of management, industry and regulatory trends, and the macroeconomic situation (Crouhy, Galai, & Mark 2006, p.238). Reviewing of credit ratings happens once a year. Changes in business information from meetings with management or new reports necessitate the review process.
3. Limitations of Credit Risk Assessment
Several factors make credit risk assessment challenging. One major challenge is that debt information may be difficult to extract in certain situations. This happens when cooperate governance does not record the limits and permissions for its business portfolios according to anticipated risk (Crouhy et al. 2006, p.98) Inefficient data management interferes with secure storage, classification, and retrieval of data. Debt information maybe inaccessible if there is no real-time database update.
Again, Crouhy et al. (2006, p.98) stated that the market prevents anticipated credit rating changes from happening. Credit rating is vital for management and maintenance of financial health of a company. However, the market controls the major factors applied in calculation of credit rating. For example, taxes and wage rates are determined by the market forces, but these liabilities affect the performance of a company’s current assets and its overall financial history (profitability).