Loans are by nature sources of change
Partnerships are by nature a source of change, so you’ll want to identify what might cause you stress in a partnership as soon as possible. The checklist in Exercise 4 will help you determine which of the most common stress points in a partnership affect you most. The statements you mark “yes” indicate areas that are likely to cause you some anxiety when it comes to change. If you dislike giving up control when performing a task, for example, you probably feel stress in a partnership when you have to do a task together. The anxiety you feel is the aftermath of the change you’re experiencing. You may try to avoid or even deny the change to prevent the anxiety—this is the normal “fight or flight” response we all experience during periods of stress.
If we can’t control the change that’s occurring around us, at least we can recognize the stressors and develop a plan to deal with them. Knowing your stressors and how you react to change is important in helping you cope with change.When two people or two organizations come together, things are bound to be different.
Assessments of an issuer’s credit quality
The rating agencies have been criticized for being too slow to react to changes in the credit quality of an issuer, leading to serially correlated rating patterns and limiting the value of ratings as a risk management tool. As a reaction, Moody’s decided to put its rating process under review, and acquired KMV to be able to provide investors with additional, marketbased assessments of an issuer’s credit quality. The feedback from market participants was surprising. Since investors themselves tend to use spreads and spread volatility as indicators for credit risk, the vast majority does not want Moody’s or the other rating agencies to switch to a more marketbased approach when assessing the credit quality of an issuer. There is really a need for, according to the feedback, more transparency with regard to the rating process. This would allow investors to use rating agency information in their risk management most efficiently.
Credit exposure to foreign currencies
European telecom companies have their operations primarily in Europe. Therefore, exposure to foreign currencies is very limited with the exception of Telefonica’s exposure to Latin America and Deutsche Telekom’s US subsidiaries. While in other industries an appreciating Euro increases competition, it appears that this effect should be negligible for the established European telecom services companies. The barriers of entry seem to be high enough to guarantee broadly stable market shares in the coming years. Since many of the telecom companies have a material fraction of their debt in US dollars, they would benefit from a strengthening Euro.
It is in the nature of financial institutions to have exposure to a variety of currencies. Exchange rate risk is therefore translational rather than transactional. By and large, long-term currency risk is primarily taken in the form of subsidiaries. Currency fluctuations change the value of the equity invested, hence are reflected in the balance sheet rather than in the P&L. Of the larger European banking groups, ABN Amro, BNP Paribas and Royal Bank of Scotland have substantial retail banking operations in the United States. In the insurance sector, Aegon, AXA, ING Verzekeringen and Prudential stand out in terms of US exposure.
When payday translation risk arises
When financial accounts are converted from one currency to another, translation risk arises. Typically, the financial accounts of foreign subsidiaries have to be translated back in the reporting currency to be included in the consolidated financial accounts. Since most companies do not hedge translation risk, significant changes in exchange rates during the reporting period can cause volatility in revenues and operating income. Usually companies present constant exchange rate revenues as an addition to reported revenues, to allow investors and creditors to analyze the effect of currency fluctuations.
However, a secular depreciation of the US dollar positively affects those European companies with part of their liabilities denominated in US dollars. Not only the amount of debt shown on the balance sheet is reduced, but also the associated interest burden is lessened. In terms of credit ratios, the issuance of debt in a currency, in which part of the revenues are generated, can provide an effective natural hedge against exchange rate volatility. For example, if profits of a European company operating in the United States were reduced by a weakening US dollar, it may be offset by a contemporaneous reduction of the level of US dollar denominated debt. In this case, credit ratios as well as interest coverage ratios could remain constant or even improve. It should be noted that revenues and earnings typically accrue gradually, hence they are translated at average exchange rates, while balance sheet figures are usually determined at the end of reporting period spot rates.
Credit affected by fluctuations of exchange rates
Credit spreads are also affected by fluctuations of exchange rates, with the USD/EUR exchange rate being the most influential one. The depreciation of the dollar that started in 2002 could potentially affect European corporate issuers if it slows economic growth and reduces demand for their products.
However, a rise of the euro against the dollar could move the ECB to cut rates and thus would impact credit spreads via the interest rate channel. The dollar weakness is mainly due to a large current account deficit, low levels of interest rates and slowing equity capital inflows. Of course, sustained fluctuations of exchange rates can impact the business of corporate borrowers as well as financial institutions. While this does not necessarily lead to significant changes in credit quality and subsequent rating actions in the short term, especially companies with a weak financial profile may find the currency issue an unwelcome challenge. A forward-looking active currency management may be based on three main factors: US inflation, European growth and comments from policymakers. However, many companies are not able or willing to manage their currency exposure actively. In this case, significant changes in exchange rates will affect companies in three ways: via transaction risk, translation risk and import competition risk.