Debt Ratings, Risk, Cancellation |
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Risk free interest rate
Lendings to stable financial entities such as large companies or governments are often termed "risk free" or "low risk" and made at a so-called "risk free interest rate". This is because the debt and interest are highly unlikely to be defaulted. A textbook example of such risk-free interest is a government bond of US government - it yields you the minimum return available in economics, but you get the security of the knowledge that US has never defaulted on its debt instruments. A risk-free rate is commonly used in setting floating interest rates, floating interest rate is usually calculated as risk-free interest rate plus a bonus to the creditor based on the creditworthiness of the debtor.
(Next paragraph is only valid for investors investing in _foreign_ risk-free debt instruments)
However if the value of a currency has changed in the meantime, the purchasing power of the money repaid may vary considerably from that which was expected at the commencement of the loan. So from a practical investment point of view, there is still considerable risk attached to "risk free" or "low risk" lendings, even though in terms of the amount of a currency that will be returned there may not be.
The Bank for International Settlements is an entity that sets rules to define what loans qualify as "risk free" or not. It is a very powerful institution, formed by the Bretton Woods agreements, which has had a pivotal position in central banking since 1947 when it opened.
Ratings and creditworthiness
Debt of countries as well as private corporations is rated by rating agencies, s.a. Moody's, A. M. Best and Standard and Poors. These agencies assess the ability of the debtor to honor his obligations and accordingly give him a credit rating. Moody's for example uses the letters Aaa Aa A Baa Ba B Caa Ca C, where ratings Aa-Caa are qualified by numbers 1-3. Munich Re, for example, currently is rated Aa3 (as of 2004). S&P and other rating agencies have slightly different systems using capital letters and +/- qualifiers.
A change in ratings can strongly affect a company, since its cost of refinancing depends on its creditworthiness. Bonds below Baa/BBB (Moody's/S&P) are considered junk- or high risk bonds. Their high risk of default is compensated by higher interest payments. Bad Debt is a loan that can not (partially or fully) be repaid by the debtor. The debtor is said to default on his debt. These types of debt are frequently repackaged and sold below face value.
Cancellation
Short of bankruptcy, very often debts are wholly or partially forgiven. Traditions in some cultures demand that this be done on a regular (often annual) basis, in order to prevent systemic inequities between groups in society, or anyone becoming a specialist in holding debt and coercing repayment.
International Third World debt has reached the scale that many economists and Christians are convinced that debt cancellation is the only way to restore global equity in relations with the developing nations.
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