MONEY & BANKING

BKF 2091

SUBMISSION DAY: 15TH FEBRUARY

BY: CRISTIAN CASSAR 601800L

KIRSTY FARRUGIA 372100L

TABLE OF CONTENTS

DEFAULT RISK- RISK TERM STRUCTURE OF INTEREST RATE 1

i) Briefly explain the concept 1

ii) Explain why it is a central concept in finance 2

iii) Use a real- life example to show a practical application of the concept 4

OPEN MARKET OPERATIONS 5

I) Briefly explain the concept 5

ii) Explain why it is a central concept in finance 6

iii) Use a real- life example to show a practical application of the concept 8

REFERENCES 10
 -DEFAULT RISK-
THE RISK STRUCTURE OF INTEREST
RATES

I) BRIEFLY EXPLAIN THE CONCEPT

Interest rates can be viewed as a vital aspect in the working of the economic system,
affecting both borrowers and investors. They have an influence on the cost of
borrowing, the return on savings as well as the return on investments. Besides this,
interest rates provide insight on future financial and economic activity. Focusing on
financial instruments, the risk term structure of interest rates can be utilized to
illustrate how bonds issued with the same maturity date will offer different interest
rates. These variations in the bonds’ yields arise due to four major factors being default
risk, liquidity, taxation, and information costs. By focusing solely on default risk, we are
referring to the probability of a borrower not being able to pay the interest or principal
according to the terms of the security. The level of default risk which a borrower may
endure depends on the borrower’s capacity, which is the ability to make timely
payments. This can be influenced by many factors such as the debtor’s financial health,
the industry and economic conditions, currency risk and political factors. High default
risk most commonly leads to higher levels of interest rates and the issuers of these
bonds will most certainly face difficulties in accessing capital markets.

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II) EXPLAIN WHY IT IS A CENTRAL CONCEPT IN FINANCE

As discussed above, one component that influences the interest rates of financial
securities that have the same maturity date is default risk. The prominence of default
risk was greatly highlighted during the 2007/2008 Financial Crisis. During this time,
default risk of instruments was underestimated due to various flaws in rating
methodologies of Credit Rating Agencies impacting many individual firms and
institutional investors. This further emphasizes the need of properly valuating the levels
of default risk as well as assessing its impact on interest rates.

According to the risk-reward trade-off, higher risk is associated with higher amounts of
return. In the case of default risk, the higher the default risk the higher the interest rate
(return). This can be further depicted in the following graph. Let’s say, for the purpose
of this example, that figure one is the market for a low-risk US Treasury Bond and figure
two is the market for a high-risk US Corporate Bond, both having the same maturity and
keeping all other things constant.

Figure 1: Market for 10-year U.S Figure 2: Market for 10-year U.S
Treasury Bond Corporate Bond

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C T
We start off with both the markets being in the same equilibrium state at P1 and P1 ,
both providing a level of interest of 4%. However, this equilibrium state will not last too
long as people who are more risk averse will opt for a default free bond. Thus, the
overall level of quantity demanded for Treasury Bonds (Figure 1) will increase, shifting
the demand curve from DT1 to D T2 . This will result in a new higher equilibrium price at
T
P2 . Since price and yield have an inverse relationship, as the price increases, the interest
rate decreases to i T2 (2%). Conversely, in the market for the riskier Corporate bond
(Figure 2), the quantity demanded will decrease, thus shifting the demand curve from
C C C
D 1 to D 2 . This results in a decrease in price to P2 and a corresponding higher interest
C
rate at i 2 (6%). Evidently, we have sustained our explanation by showing that bonds
having the same maturity, but different levels of default risk, will yield different interest
rates. In Figure 2, we have shown how bonds carrying a higher degree of risk will yield
higher levels of return. This can be referred to as the risk premium, the compensation
given to the bond holder for taking on more risky bonds, seen as the difference between
T C
i 2 and i 2 .

Subsequently, since the degree of risk of a bond is a major determining factor of the
interest rate which it holds, potential investors would want to know the level of risk
associated with every bond. Credit Rating Agencies are investment advisory companies
that give a rating to the quality of bonds in terms of the level of default risk which they
hold. It is important that these agencies, such as Moody’s and the Fitch Ratings, have no
miscalculations as all individuals refer to these ratings to make an informed decision on
which bond to invest in.

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III) USE A REAL- LIFE EXAMPLE TO SHOW A PRACTICAL

APPLICATION OF THE CONCEPT

According to the Fitch Ratings, bonds which carry a relatively low level of default risk
are called investment-grade securities, carrying a rating of BBB- or higher. On the other
hand, securities with a higher level of risk are called speculative bonds having a rating
of BB+ or lower.

Let us compare the credit rating of four countries issuing a 10-year bond according to
the Fitch Ratings:

Country Credit Rating Interest Rate

Sweden AAA 0.090%
Malta A+ 0.252%
Morocco BB+ 2.185%
Sri Lanka CCC 8.030%
As of 24th January 2021

Sweden’s AAA credit rating reflects the country’s wealth together with a strong
economic growth. These signify a high resistance to potential economic slowdowns. Due
to this, Sweden carries low risk and thus a low interest rate. On the other hand, Sri
Lanka has a higher interest rate of 8.030%. The CCC rating reflects the country’s
increasing external-debt repayment position. Mainly, a sharp increase in the sovereign
debt to GDP ratio relating to the COVID-19 shock. Thus, making the country riskier
leading to higher interest rates.

The same applies for the local context. Malta’s A+ rating is supported by high per capita
income levels together with a substantial net external creditor position. Additionally,
Malta is also an EU and eurozone member. All these strengths make up for the large
banking sector and the highly open nature of the economy. Fitch’s expectations show
that the GDP growth will recover and the budget deficit will decrease in 2021 and 2022,
slowly adjusting to the coronavirus’ impact on the tourism sector and public finances.
Thus, Malta is considered to have low risk and so a corresponding low interest rate.

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OPEN MARKET OPERATIONS

I) BRIEFLY EXPLAIN THE CONCEPT

Central banks around the globe have a multitude of objectives, however, ensuring
financial stability in their economy is imperative. Central banks may achieve this
through several tools and policies, one of the most prominent being the monetary
policy. Through this policy, central banks manipulate the money supply in their
economy to promote sustainable growth and ensure that the economy is neither
growing too fast nor too slow. A paramount tool used to implement monetary policy is
open market operations, which involves trading of government securities between the
central bank, banks and the non-bank public. The central bank may purchase
government bonds from the bank and non-bank public, thus increasing the money
supply in the economy. Conversely, a central bank may sell government bonds to banks
and non-bank public, hence reducing the money supply. Consequently, since open
market operations affect the money supply, interest rates will fluctuate in accordance
with the law of demand and supply.

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II) EXPLAIN WHY IT IS A CENTRAL CONCEPT IN FINANCE

Central banks have several other tools at their disposal to implement monetary policy,
however, trading of securities is considered to affect economic activity in a more timely
and effective manner, than other tools. For this reason, open market operations is one of
the most popular tools of monetary policy. As aforementioned, open market operations
impose a direct impact on the money supply. However, central banks see beyond this,
such that they aim to influence other factors through the manipulation of the money
supply.

For instance, during periods of high economic growth, the inflation rate of a country is
susceptible to increase. However, central banks aim to keep the inflation rate constant,
to maintain sustainable growth. To adjust for this increase in the inflation rate, a central
bank would need to implement a contractionary monetary policy, which could be
executed through open market sales where, the central bank sells government bonds to
banks and the non-bank public. In doing so, the central bank would be reducing the
amount of funds which banks may use to lend to its customers. As a consequence of this,
since the supply of money has decreased, short term interest rates will rise. This is
depicted in Figure 3.

Figure 3 – Increase in interest rate brought about by a decrease in

money supply. 6
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This increase in interest rates, will now make it more difficult for the public and
companies to take out loans. Consequently, economic activity will now be reduced and
therefore the rate at which the economy is growing will be slowed down. This
slowdown in the economy will eventually adjust the inflation rate to a desirable level
(usually between 2% - 3%).

Moreover, open market operations are also used to implement an expansionary

monetary policy during periods of economic slowdown, where unemployment levels
are high. In order to stimulate the economy during these periods, central banks will
engage in buying government bonds from banks (open market purchases). In doing so,
the central bank would be increasing the money supply in the economy, thus, banks
have access to more funds to lend to their customers. This will result in a decrease in
the short-term interest rates, therefore making it easier for individuals and businesses
to take out loans. This decrease in short term interest rates is depicted in figure 4.

Figure 4 – Decrease in interest rate brought about by an increase in

money supply

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This decrease in interest rates would mean that individuals and businesses will find it
easier to take out a mortgage and start up or expand already existing businesses. These
series of events will eventually start to increase economic activity and thus improving
the economic growth rate. When this process commences, unemployment levels will
start to decrease.

Evidently, open market operations is a very powerful tool used to manipulate the
economy by adjusting the money supply. This tool affects numerous factors including
interest rates, inflation levels and unemployment which will ultimately lead to achieving
the desired level of economic activity.

III) USE A REAL-LIFE EXAMPLE TO SHOW A PRACTICAL

APPLICATION OF THE CONCEPT

As previously explained, open market operations is a very effective monetary policy

tool, which may be utilised either when the level of economic activity is booming or
when it is sluggish. Undoubtedly, as a result of the Covid-19 global pandemic, economies
around the globe are being faced with threatening scenarios since economic activities
have taken a downturn. As a consequence of this, central banks have been working
constantly in order to minimise the effects of this pandemic and try to regain the
momentum at which their economies are growing. Central banks are now making use of
open market operations in order to reach their targets.

The Reserve Bank of India (RBI), is one of the many central banks which is making use
of this tool to fight the effects of Covid-19. Although restrictions are being lifted and
business are re-operating, the RIB said that journey to arrive to economic levels pre
Covid-19 is a long one. Therefore, to facilitate this, the RIB is making use of open market
operations, where they aim to increase liquidity and promote efficient pricing for loans.
Similarly, the People’s Bank of China conducted reverse repo operations in the amount

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of ¥100 billion on August 27, 2020 with the aim of keeping liquidity in the banking
system adequate at a reasonable level.

The U.S. Federal system (Fed), prior to the global financial crisis (2007/8), did not
utilize open market operations as much. However, from the end of 2008 up until to
2014, the Fed had increased its asset purchases (through open market operations)
significantly. In fact, at the end of 2014, the Fed had around $4.5 trillion assets, which
was around five times greater than the levels it had pre-crisis. The Fed had stated that
this was done so that long-term interest rates fall hence, stimulating economic activity
and eventually lead to higher employment rates.

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REFERENCES

• Business-standard.com. 2021. RBI to conduct simultaneous sale-purchase of govt

securities on Jan 7. [online] Available at:
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simultaneous-sale-purchase-of-govt-securities-on-jan-7-121010100324_1.html>
[Accessed 7 February 2021].
• Adb.org. 2010. The Financial Crisis And The Regulation Of Credit Rating Agencies:
A European Banking Perspective. [online] Available at:
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[Accessed 24 January 2021].
• Board of Governors of the Federal Reserve System. 2021. Federal Reserve Board -
Open Market Operations. [online] Available at:
<https://www.federalreserve.gov/monetarypolicy/openmarket.htm> [Accessed
7 February 2021].
• Corporate Finance Institute. n.d. Default Risk - Overview, Assessment, And Key
Factors. [online] Available at:
<https://corporatefinanceinstitute.com/resources/knowledge/credit/default-
risk/#:~:text=Therefore%2C%20default%20risk%20is%20key,which%20may
%20affect%20funding%20potential).> [Accessed 24 January 2021].
• countryeconomy.com. 2021. Sweden - 10-Year Government Bond Yield 2021.
[online] Available at: <https://countryeconomy.com/bonds/sweden> [Accessed
24 January 2021].
• Fas.org. 2021. [online] Available at: <https://fas.org/sgp/crs/misc/RL30354.pdf>
[Accessed 7 February 2021].
• Fitchratings.com. 2020. Fitch Affirms Malta At 'A+'; Outlook Stable. [online]
Available at: <https://www.fitchratings.com/research/sovereigns/fitch-affirms-
malta-at-a-outlook-stable-04-12-2020> [Accessed 24 January 2021].
• Fitchratings.com. 2020. Fitch Downgrades Sri Lanka To 'CCC'. [online] Available
at: <https://www.fitchratings.com/research/sovereigns/fitch-downgrades-sri-
lanka-to-ccc-27-11-2020> [Accessed 24 January 2021].

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• Icmagroup.org. 2021. COVID-19 Market Updates: Monetary policy. [online]

Available at: <https://www.icmagroup.org/Regulatory-Policy-and-Market-
Practice/covid-19-market-updates/monetary-policy/> [Accessed 7 February
2021].
• Investing.com. 2021. Malta 10-Year Bond Yield - Investing.com. [online] Available
at: <https://www.investing.com/rates-bonds/malta-10-year> [Accessed 24
January 2021].
• Investing.com. 2021. Morocco 10-Year Bond Yield - Investing.com. [online]
Available at: <https://www.investing.com/rates-bonds/morocco-10-year>
[Accessed 24 January 2021].
• Investing.com. 2021. Sri Lanka 10-Year Bond Yield - Investing.com. [online]
Available at: <https://www.investing.com/rates-bonds/sri-lanka-10-year>
[Accessed 24 January 2021].
• Investment, I., Europe?, W., Income, M. and read, M., n.d. Which Are The Safest
Government Bond Markets In Europe?. [online] InternationalInvestment.
Available at:
<https://www.internationalinvestment.net/internationalinvestment/news/
3706059/safest-government-bond-markets-europe> [Accessed 24 January 2021].
• Investopedia. 2021. How Do the Fed's Open Market Operations Affect the U.S.
Money Supply?. [online] Available at:
<https://www.investopedia.com/ask/answers/06/openmarketoperations.asp>
[Accessed 7 February 2021].
• Patton, M., 2016. The Importance Of Interest Rates To Investors, Retirees, And
The Economy. [online] Forbes. Available at:
<https://www.forbes.com/sites/mikepatton/2016/01/30/the-importance-of-
interest-rates-to-the-economy-investors-and-retirees/?sh=70f80b766cbc>
[Accessed 24 January 2021].
• Rbi.org.in. 2021. Reserve Bank of India - Press Releases. [online] Available at:
<https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50480>
[Accessed 7 February 2021].
• Rbi.org.in. 2021. Reserve Bank of India - Press Releases. [online] Available at:
<https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50624>
[Accessed 7 February 2021].

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• Stlouisfed.org. 2021. FOMC: Federal Open Market Committee | In Plain English |

St. Louis Fed. [online] Available at: <https://www.stlouisfed.org/in-plain-
english/a-closer-look-at-open-market-operations> [Accessed 7 February 2021].
• Tradingeconomics.com. 2021. Credit Rating - Countries - List. [online] Available
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2021].

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