CREDIT RATING METHODOLOGIES
(ii) FINANCIAL RISK
Financial Risk is referred as the unexpected changes in financial conditions such as prices, exchange rate, Credit rating, and interest rate etc. Though political risk is not a financial risk in direct sense but same can be included as any unexpected political change in any foreign country may lead to country risk which may ultimately result in financial loss.
Accordingly, the broadly Financial Risk can be divided into following categories.
(a) Counter Party Risk
(b) Political Risk
(c) Interest Rate Risk
(d) Currency Risk
Now, let us discuss each of the above mentioned risks:
Financial Risk is referred as the unexpected changes in financial conditions such as prices, exchange rate, Credit rating, and interest rate etc. Though political risk is not a financial risk in direct sense but same can be included as any unexpected political change in any foreign country may lead to country risk which may ultimately result in financial loss.
Accordingly, the broadly Financial Risk can be divided into following categories.
(a) Counter Party Risk
(b) Political Risk
(c) Interest Rate Risk
(d) Currency Risk
Now, let us discuss each of the above mentioned risks:
(a) Counter Party Risk
This risk occurs due to non honoring of obligations by the counter party which can be failure to deliver the goods for the payment already made or vice-versa or repayment of borrowings and interest etc.
Thus, this risk also covers the credit risk i.e. default by the counter party.
(b) Political Risk
Generally this type of risk is faced by overseas investors, as the adverse action by the government of host country may lead to huge loses. This can be on any of the following forms :
- Confiscation or destruction of overseas properties.
- Rationing of remittance to home country.
- Restriction on conversion of local currency of host country into foreign currency.
- Restriction as borrowings.
- Invalidation of Patents
- Price control of products
(c) Interest Rate Risk
This risk occurs due to change in interest rate resulting in change in asset and liabilities. This risk is more important for banking companies as their balance sheet’s items are more interest sensitive and their base of earning is spread between borrowing and lending rates.
As we know that the interest rates are of two types i.e. fixed and floating. The risk in both of these types is inherent. If any company has borrowed money at floating rate then with increase in floating rate the liability under fixed rate shall remain the same. This fixed rate, with falling floating rate the liability of company to pay interest under fixed rate shall comparatively be higher.
(d) Currency Risk
This risk mainly affects the organization dealing with foreign exchange as their cash flows changes with the movement in the currency exchange rates. This risk can affect the cash flow adversely or favorably. For example, if rupee depreciates vis-à-vis US$ receivables will stand to gain vis-à-vis to the importer who has the liability to pay bill in US$. The best case we can quote, Infosys (Exporter) and Indian Oil Corporation Ltd. (Importer).
This risk occurs due to change in interest rate resulting in change in asset and liabilities. This risk is more important for banking companies as their balance sheet’s items are more interest sensitive and their base of earning is spread between borrowing and lending rates.
As we know that the interest rates are of two types i.e. fixed and floating. The risk in both of these types is inherent. If any company has borrowed money at floating rate then with increase in floating rate the liability under fixed rate shall remain the same. This fixed rate, with falling floating rate the liability of company to pay interest under fixed rate shall comparatively be higher.
(d) Currency Risk
This risk mainly affects the organization dealing with foreign exchange as their cash flows changes with the movement in the currency exchange rates. This risk can affect the cash flow adversely or favorably. For example, if rupee depreciates vis-à-vis US$ receivables will stand to gain vis-à-vis to the importer who has the liability to pay bill in US$. The best case we can quote, Infosys (Exporter) and Indian Oil Corporation Ltd. (Importer).
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