Credit Risk Spreads in Local and Foreign Currencies

IMF Working Papers, May 1, 2009

Source details

Title: Credit Risk Spreads in Local and Foreign Currencies
Authors: Zvi Wiener, Dan Galai
Date: May 1, 2009
Core premise: In a Merton-type model with bankruptcy, the currency composition of debt changes the risk profile of a company raising a given amount of financing, and thus affects the cost of debt.

The currency composition of debt alters a firm's risk profile and therefore its cost of debt in the Merton-type bankruptcy framework.
Foreign currency borrowing can be cheaper when the exchange rate is positively correlated with the return on the company's assets, even if the company is not an exporter.
Prudential regulations should differentiate among loans depending on the extent to which borrowers have "natural hedges" of their foreign currency exposures.

Analytical framework: Merton-type model with bankruptcy.
Focus: Effect of currency composition of debt on credit risk spreads and cost of debt.
Subject tags provided: Bonds, Credit, Credit risk, Currencies, Exchange rates, Financial institutions, Financial regulation and supervision, Foreign exchange, Money.
Keywords provided include: bond, Bonds, capital structure, Credit, Credit risk, credit spread, Currencies, currency composition, currency exposure, currency mismatch, dollarization, euro currency, euro debt, Exchange rates, expected return, foreign currency bond, foreign debt, Global, Merton’s model, rate of exchange rate fluctuation, rate of return on equity, South America, WP, yield to maturity.

Prudential regulation: Differentiate regulatory treatment of loans based on borrowers' natural hedges against foreign currency exposures.
Risk assessment: Incorporate the correlation between exchange rates and firm asset returns when assessing cost of foreign currency borrowing.

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