A Swap is a derivative in which two counterparties agree to exchange one stream of cash flow against another stream. Swaps can be used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral. It can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

This project is based on the feasibility of swaps in the developing countries especially after the recession which was due to the subprime crisis. I would study how the swaps are used to create unfunded exposures to underlying assets without been exchanged between the counterparties who can earn profit with the movements in price especially in the developing countries and how this can lead to the credit valuation of the companies in the developing countries.

My primary research question would be are swaps feasible in developing countries where there is no agency to value the credit ratings of the companies. Also, would corruption and parallel economy running in many developing countries have an effect on the credit valuation of the companies and how introduction of swaps can help or destroy the economy of these countries.

In finance, a SWAP is a derivative in which two counterparties agree to exchange one stream of cash flow against another stream. These streams are called the legs of the swap. Conventionally they are the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed.

A swap is an agreement to exchange one stream of cash flows for another. Swaps are most usually used to:-

  • Switch financing in one country for financing in another
  • To replace a floating interest rate swap with a fixed interest rate (or vice versa)

(Litzenberger, R.H)In August 1981 the World Bank issued $290 million in euro-bonds and swapped the interest and principal on these bonds with IBM for Swiss francs and German marks. The rapid growth in the use of interest rate swaps, currency swaps, and swaptions (options on swaps) has been phenomenal. Currently, the amount of outstanding interest rate and currency swaps is almost $3 trillion.

Recently, swaps have grown to include currency swaps and interest rate swaps. It can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates.

Different types of swaps:-

Currency Swaps

Cross currency swaps are agreements between counterparties to exchange interest and principal payments in different currencies. Like a forward, a cross currency swap consists of the exchange of principal amounts (based on today's spot rate) and interest payments between counterparties. It is considered to be a foreign exchange transaction and is not required by law to be shown on the balance sheet.

In a currency swap, these streams of cash flows consist of a stream of interest and principal payments in one currency exchanged for a stream, of interest and principal payments of the same maturity in another currency. Because of the exchange and re-exchange of notional principal amounts, the currency swap generates a larger credit exposure than the interest rate swap.

Cross-currency swaps can be used to transform the currency denomination of assets and liabilities. They are effective tools for managing foreign currency risk. They can create currency match within its portfolio and minimize exposures. Firms can use them to hedge foreign currency debts and foreign net investments.

Currency swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets. Currency swaps allow companies to exploit advantages across a matrix of currencies and maturities.

Currency swaps were originally done to get around exchange controls and hedge the risk on currency rate movements. It also helps in Reducing costs and risks associated with currency exchange.

They are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies shop for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency.

Credit Default Swap

Credit Default Swap is a financial instrument for swapping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond.

  • The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted.
  • The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap.

The first credit default swap was introduced in 1995 by JP Morgan. By 2007, their total value has increased to an estimated $45 trillion to $62 trillion. Although since only 0.2% of Investment Company's default, the cash flow is much lower than this actual amount. Therefore, this shows that credit default swaps are being used for speculation and not insuring against actual bonds.

As Warren Buffett calls them "financial weapons of mass destruction". The credit default swaps are being blamed for much of the current market meltdown.

Example of Credit Default Swap

  • An investment trust owns £1 million corporation bond issued by a private housing firm.
  • If there is a risk the private housing firm may default on repayments, the investment trust may buy a CDS from a hedge fund. The CDS is worth £1 million.
  • The investment trust will pay an interest on this credit default swap of say 3%. This could involve payments of £30,000 a year for the duration of the contract.
  • If the private housing firm doesn't default. The hedge fund gains the interest from the investment bank and pays nothing out. It is simple profit.
  • If the private housing firm does default, then the hedge fund has to pay compensation to the investment bank of £1 million - the value of the credit default swap.
  • Therefore the hedge fund takes on a larger risk and could end up paying £1million The higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.

Commodity Swap

A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve oil. A swap where exchanged cash flows are dependent on the price of an underlying commodity. This swap is usually used to hedge against the price of a commodity. Commodities are physical assets such as precious metals, base metals, energy stores (such as natural gas or crude oil) and food (including wheat, pork bellies, cattle, etc.).

In this swap, the user of a commodity would secure a maximum price and agree to pay a financial institution this fixed price. Then in return, the user would get payments based on the market price for the commodity involved.

They are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between final product and raw material prices.

A company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. There are two kinds of agents participating in the commodity markets: end-users (hedgers) and investors (speculators).

Commodity swaps are becoming increasingly common in the energy and agricultural industries, where demand and supply are both subject to considerable uncertainty. For example, heavy users of oil, such as airlines, will often enter into contracts in which they agree to make a series of fixed payments, say every six months for two years, and receive payments on those same dates as determined by an oil price index. Computations are often based on a specific number of tons of oil in order to lock in the price the airline pays for a specific quantity of oil, purchased at regular intervals over the two-year period. However, the airline will typically buy the actual oil it needs from the spot market.

Equity Swap

The outstanding performance of equity markets in the 1980s and the 1990s, have brought in some technological innovations that have made widespread participation in the equity market more feasible and more marketable and the demographic imperative of baby-boomer saving has generated significant interest in equity derivatives. In addition to the listed equity options on individual stocks and individual indices, a burgeoning over-the-counter (OTC) market has evolved in the distribution and utilization of equity swaps.

An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. An exchange of the potential appreciation of equity's value and dividends for a guaranteed return plus any decrease in the value of the equity. An equity swap permits an equity holder a guaranteed return but demands the holder give up all rights to appreciation and dividend income. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do have.

Equity swaps make the index trading strategy even easier. Besides diversification and tax benefits, equity swaps also allow large institutions to hedge specific assets or positions in their portfolios

The equity swap is the best swap amongst all the other swaps as it being an over-the-counter derivatives transaction; they have the attractive feature of being customizable for a particular user's situation. Investors may have specific time horizons, portfolio compositions, or other terms and conditions that are not matched by exchange-listed derivatives. They are private transactions that are not directly reportable to any regulatory authority.

A derivatives dealer can, through a foreign subsidiary in the particular country, invest in the foreign securities without the withholding tax and enter into a swap with the parent dealer company, which can then enter a swap with the American investor, effectively passing on the dividends without the withholding tax

Interest Rate Swap

An interest rate swap, or simply a rate swap, is an agreement between two parties to exchange a sequence of interest payments without exchanging the underlying debt. In a typical fixed/floating rate swap, the first party promises to pay to the second at designated intervals a stipulated amount of interest calculated at a fixed rate on the "notional principal"; the second party promises to pay to the first at the same intervals a floating amount of interest on the notional principle calculated according to a floating-rate index.

The interest rate swap is essentially a strip of forward contracts exchanging interest payments. Thus, interest rate swaps, like interest rate futures or interest rate forward contracts, offer a mechanism for restructuring cash flows and, if properly used, provide a financial instrument for hedging against interest rate risk

The reason for the exchange of the interest obligation is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. In an interest rate swap they consist of streams of interest payments of one type (fixed or floating) exchanged for streams of interest payments of the other-type in the same currency

Interest rate swaps are voluntary market transactions by two parties. In an interest swap, as in all economic transactions, it is presumed that both parties obtain economic benefits. The economic benefits in an interest rate swap are a result of the principle of comparative advantage. Further, in the absence of national and international money and capital market imperfections and in the absence of comparative advantages among different borrowers in these markets, there would be no economic incentive for any firm to engage in an interest rate swap.

Differential information and institutional restrictions are the major factors that contribute to the differences in transactions costs in both the fixed-rate and the floating-rate markets across national boundaries which, in turn, provide economic incentive to engage in an interest rate swap.

Interest rate swaps have become one of the most popular vehicles utilized by many companies and financial institutions to hedge against interest rate risk. The growing popularity of interest rate swaps is due, in part, to the fact that the technique is simple and easy to execute. The most widely used swap is a fixed/floating interest rate swap.

Interest rates

London Interbank Offered Rate (LIBOR)

The London Interbank Offered Rate (or LIBOR ) is a daily reference rate based on the interest rates at which banks borrow unsecured funds from other banks in the London wholesale money market (or interbank market).

LIBOR is the rate of interest offered by banks on deposit from other banks in the Eurocurrency market. One-month LIBOR is the rate offered for 1-month deposits, 3-month LIBOR for three months deposits, etc. LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the International Market.

LIBOR is calculated by Thomson Reuters and published by the British Bankers' Association (BBA) after 11:00 am (and generally around 11:45 am) each day (London time). It is a trimmed average of inter-bank deposit rates offered by designated contributor banks, for maturities ranging from overnight to one year. LIBOR is calculated for 10 currencies. There are either eight, twelve or sixteen contributor banks on each currency panel and the reported interest is the mean of the middle values (the interquartile mean). The rates are a benchmark rather than a tradable rate, the actual rate at which banks will lend to one another continues to vary throughout the day.

Floating Interest

A floating interest rate, also known as a variable rate or adjustable rate, refers to any type of debt instrument, such as a loan, bond, mortgage, or credit, that does not have a fixed rate of interest over the life of the instrument. An interest rate that is allowed to move up and down with the rest of the market or along with an index.

It is determined using an index or other base rate for establishing the interest rate for each relevant period. One of the most common rates to use as the basis for applying interest rates is the London Inter-bank Offered Rate, or LIBOR (the rates at which large banks lend to each other). The rate for such debt will usually be referred to as a spread or margin over the base rate

Typically, floating rate loans will cost less than fixed rate loans, depending in part on the yield curve. In return for paying a lower loan rate, the borrower takes the interest rate risk: the risk that rates will go up in future.

Fixed Interest Rate

A loan or mortgage with an interest rate that will remain at adetermined rate for the entire term of the loan. Fixed-rate mortgages are the most common mortgage for first-time homebuyers because they're stable. Typically the monthly mortgage payment remains the same for the entire term of the loan.

A fixed interest rate is based on the lender's assumptions about the average discount rate over the fixed rate period.

Benefits of fixed interest:-

  • Inflation protection.If interest rates increase, your mortgage and your mortgage payment won't be affected.
  • Long-term planning.You know what your monthly mortgage expense will be for the entire term of your mortgage. This can help you plan for other expenses and long-term goals.
  • Low risk. You always know what your mortgage payment will be, regardless of the current interest rate.

Credit Ratings

A credit rating estimates the credit worthiness of an individual, corporation, or even a country. It is an evaluation made by credit bureaus of a borrower's overall credit history. A credit rating is also known as an evaluation of a potential borrower's ability to repay debt, prepared by a credit bureau. Credit ratings are calculated from financial history and current assets and liabilities. Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. However, in recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit.

Credit ratings provide individual and institutional investors with information that assists them in determining whether issuers of debt obligations and fixed-income securities will be able to meet their obligations with respect to those securities. Credit rating agencies provide investors with objective analyses and independent assessments of companies and countries that issue such securities. Globalization in the investment market, coupled with diversification in the types and quantities of securities issued, presents a challenge to institutional and individual investors who must analyze risks associated with both foreign and domestic investments.

Credit ratings carry considerable weight in financial markets, both in terms of business practice and regulatory requirements. Sometimes a rating is wrongly judged as an audit of the issuing company.

Credit Rating Agencies

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued.

The main activity of credit rating agencies is to issue opinions on the creditworthiness of a particular issuer or financial instrument, or the likelihood that it will honour its financial obligations. Credit ratings are divided up into categories, going from low-risk or investment grade to high-risk or speculative grade.

Credit rating agencies are important players in financial markets. Collecting information is expensive and rating agencies are able to process information in an efficient way.

Investors expect that credit rating agencies comply with reporting procedures developed by securities industry governing agencies, and that the ratings are not biased towards a company and are true to their knowledge. Understanding the history and evolution of ratings agencies gives investors insight on the methodology that agencies use, as well as the quality of ratings from each agency. The analyses and assessments provided by various credit rating agencies provide investors with information and insight that facilitates their ability to examine and understand the risks and opportunities associated with various investment environments. With this insight, investors can make informed decisions as to the countries, industries and classes of securities in which they choose to invest.


Costs and benefits of obtaining a rating

The primary purpose of obtaining a rating is to enhance access to private capital markets and lower debt issuance and interest costs. Theoretical work of Ramakrishnanand Thakor, 1984; Millon and Thakor, 1985 suggests that credit rating agencies, in their role as information gatherers and processors, can reduce a firm's capital costs by certifying its value in a market, thus solving or reducing the informative asymmetries between purchasers and issuers.

Booms and busts: financial crises in emerging markets and the pro-cyclicality ofRatings

Not only do international capital markets react to changes in the ratings, but the ratings systematically respond, with a lag to market conditions as reflected in the sovereign bond yield spreads (Larrain et al., 1997; Reisen and von Maltzan, 1997)

Accuracy and performance of ratings

Credit Rating Agencies' failure to predict the Mexican and Asian financial crises was due, among other things, to the fact that contingent liability and international liquidity considerations had not been taken into account by CRAs.

Impact of ratings on policies pursued by borrowing countries

For borrowing countries, a rating downgrade has negative effects on their access to credit and the cost of their borrowing (Cantor and Packer, 1996). Although precise information is not available on the way in which macroeconomic policies are taken into consideration by CRA's in establishing sovereign ratings, it is reasonable to assume that orthodox policies focusing on the reduction of inflation and government budget deficits are favoured. There is a risk, therefore, that in order to avoid rating downgrades, borrowing countries adopt policies that address the short-term concerns of portfolio investors, even when they are in conflict with long-term development needs.

There is a growing concern that investors, particularly institutional investors, rely on ratings without performing their own credit analysis, and the herd behaviour resulting from relying solely on ratings.

The subprime mortgage crisis that began in the summer of 2007 echoed the concerns about investor over-reliance on ratings.

More and more investors believe that the credit rating companies have too great an influence on a company's balance sheet and ultimately the cost of running the business - in many cases existing shareholders are losing out in some shape or form.

(Marwan Elkhoury)Credit rating agencies (CRAs) play a key role in financial markets by helping to reduce the informative irregularity between lenders and investors, on one side, and issuers on the other side, about the creditworthiness of companies or countries. Credit rating agencies specialize in analysing and evaluating the creditworthiness of corporate and sovereign issuers of debt securities. In the new financial architecture, CRAs are expected to become more important in the management of both corporate and sovereign credit risk.

Issuers with lower credit ratings pay higher interest rates embodying larger risk premiums

than higher rated issuers. Moreover, ratings determine the eligibility of debt and other

financial instruments for the portfolios of certain institutional investors due to national

regulations that restrict investment in speculative-grade bonds.

As defined by Nagy (1984), "Country risk is the exposure to a loss in cross-border lending, caused by events in a particular country which are - at least to some extent - under the control of the government but definitely not under the control of a private enterprise or individual".

However, sovereign and country risks are highly correlated as the government is the major factor affecting both.

The value of credit rating agencies have been widely questioned after the 2008 financial crisis. They have been subject to the following criticisms:

* Credit rating agencies do not downgrade companies promptly enough. For example, Enron's rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the company's problems for months.

* Large corporate rating agencies have been criticized for having too familiar a relationship with company management, possibly opening themselves to undue influence or the vulnerability of being misled. These agencies meet frequently in person with the management of many companies, and advise on actions the company should take to maintain a certain rating. Furthermore, because information about ratings changes from the larger CRAs can spread so quickly (by word of mouth, email, etc.), the larger CRAs charge debt issuers, rather than investors, for their ratings. This has led to accusations that these CRAs are plagued by conflicts of interest that might inhibit them from providing accurate and honest ratings. The CRA's drive companies to consider how a proposed activity might affect their credit rating, possibly at the expense of employees, the environment, or long-term research and development.

* The lowering of a credit score by a CRA can create a vicious cycle, as not only interest rates for that company would go up, but other contracts with financial institutions may be affected adversely, causing an increase in expenses and ensuing decrease in credit worthiness. In some cases, large loans to companies contain a clause that makes the loan due in full if the companies' credit rating is lowered beyond a certain point (usually a "speculative" or "junk bond" rating). The purpose of these "ratings triggers" is to ensure that the bank is able to lay claim to a weak company's assets before the company declares bankruptcy and a receiver is appointed to divide up the claims against the company. The effect of such ratings triggers, however, can be devastating: under a worst-case scenario, once the company's debt is downgraded by a CRA, the company's loans become due in full; since the troubled company likely is incapable of paying all of these loans in full at once, it is forced into bankruptcy (a so-called "death spiral"). These rating triggers were instrumental in the collapse of Enron. Since that time, major agencies have put extra effort into detecting these triggers and discouraging their use,

  • Agencies are sometimes accused of being oligopolists, because barriers to market entry are high and rating agency business is itself reputation-based (and the finance industry pays little attention to a rating that is not widely recognized).
  • Credit Rating Agencies have made errors of judgment in rating structured products, particularly in assigning AAA ratings to structured debt, which in a large number of cases has subsequently been downgraded or defaulted. This has led to problems for several banks whose capital requirements depend on the rating of the structured assets they hold, as well as large losses in the banking industry. AAA rated mortgage securities trading at only 80 cents in the dollar, implying a greater than 20% chance of default, and 8.9% of AAA rated structured CDOs are being considered for downgrade, which expects most to downgrade to an average of BBB to BB-. These levels of reassessment are surprising for AAA rated bonds, which have the same rating class as US government bonds. Most rating agencies do not draw a distinction between AAA on structured finance and AAA on corporate or government bonds (though their ratings releases typically describe the type of security being rated).
  • Many institutional investors relied solely on the ratings agencies rather than conducting their own analysis of the risks these instruments posed.
  • Conflicts of interest often arise because the rating agencies are paid by the companies issuing the securities — an arrangement that has come under fire as a disincentive for the agencies to be vigilant on behalf of investors. Many market participants no longer rely on the credit agencies ratings systems, even before the economic crisis of 2007-8, preferring instead to use credit spreads to benchmarks like Treasuries or an index. However, since the Federal Reserve requires that structured financial entities be rated by at least two of the three credit agencies they have a continued obligation.
  • Many of the structured financial products that they were responsible for rating, consisted of lower quality 'BBB' rated loans, but were when pooled together into CDOs they were assigned an AAA rating. The strength of the CDO was not wholly dependent on the strength of the underlying loans, but in fact the structure assigned to the CDO in question.
  • credit rating agencies were aggressive in rating structured finance products, and often sign optimistic ratings due to rating shopping;
  • their model and parameters are wrong, underestimating risks of financial products;
  • Corporate governance issues like failure of top management to value risk.

It'sbeen believed worldwide the credit crunch affecting the world economy was majorly due to the faulty credit rating agencies and the value of the credit rating agencies have been widely questioned after the subprime crisis of United States of America which were the root cause of the financial crisis of 2008.

Countries are issued sovereign credit ratings. This rating analyzes the general creditworthiness of a country or foreign government. Sovereign credit ratings take into account the overall economic conditions of a country including the volume of foreign, public and private investment, capital market transparency and foreign currency reserves. Sovereign ratings also assess political conditions such as overall political stability and the level of economic stability a country will maintain during times of political transition.

United States Credit Rating

The United States is at risk of losing its triple-A credit rating unless it starts putting its finances in order, Signs are abound that America is in even worse shape now, and that confidence in America's ability to gain control of its finances is eroding. The proposed changes would also try to stop the practice of companies "shopping" for the best rating from credit rating agencies.

The Obama administration and Federal Reserve are attempting to walk a fine line on spending. To combat the recession, they created a number of programs with multibillion-dollar price tags. But as the downturn has shown signs of slowing, they have started to emphasize their commitment to deficit busting.

Credit rating agencies may want to revaluate their use of the First Amendment as a defence against liability arising from ratings they issued on subprime investment products that eventually soured.

As U.S. retailers continue to effectively manage inventories, costs, and cash flows, Rating Outlooks are likely to stabilize following the recession,

Despite the fully developed economy and the credit rating agency of United States, the credit agencies of United States were criticized for contributing to the 2008 global financial crisis by giving top ratings to risky debt that later dropped in value. Those ratings gave investors a false and dangerous sense of security. The rating agencies were paid above-normal fees that were in par. which resulted in the collapse of large financial institutions, the "bail out" of banks by national governments and downturns in stock markets around the world. It was considered by many economists to be the worst financial crisis since the Great Depression of the 1930s.

In India where corruption plays a major role in every possible sector, the credit rating agencies could be bribed off easily and the companies could get a better credit rating which could further result in an economy downturn and the economy could face a bigger financial crisis than the United States.

United Kingdom Credit Rating

While the UKhas been severely hit by the global economic and financial crisis, credit rating agency Moody's says it does not expect to strip the country of itsprized triple arating. The agency said the UK, alongside the US, counts among the countries least vulnerable to a downgrade.

UK debt was relatively low ahead of the crisis and is not likely toexceeddebt of other large ‘AAA' sovereigns - which are also experiencing large fiscal shocks. In May, Standard & Poor's said UK measures to stabilise theeconomy have threatened the UK's prized triple A credit rating and changed its outlook on the country's rating to 'negative' from 'stable'. It is set to keep its top triple-A credit status after ratings agency Moody's announced that a downgrade was unlikely despite spiralling public debt.

Gross public debt had almost doubled to above 80% of GDP in three years and was not expected to stabilise for many years to come

But a downgrade of the UK's credit rating, which would drive up the government's borrowing costs, had been averted because of the growing political consensus on the need to cut public spending as the economy recovered. It had significant advantages that meant its debt would remain affordable. A big proportion of UK debt is long-dated, which means its cost will not rise rapidly if interest rates go up.

China's Credit Rating

Standard & Poor's raised China's long-term sovereign credit rating to A+ from A with a stable outlook, saying that the government's improving balance sheet will offer greater resilience to deal with a potential sharp economic slowdown. The standards were announced by Dagong Global Credit Rating Co Ltd, one of the first domestic rating agencies in China.

China unveiled credit rating standards for the sovereignty entity of a central government, the first sovereign credit rating standards in China, aiming broader participation in global credit rating.

The launch of the sovereign credit rating standards would help improve the transparency of credit rating information, and would strengthen China's position in the international financial arena (Xinhua). As a professional service which unveils the risk in capital markets and serves the investing public, the credit rating business has become a major tool of supervision,

The sovereign credit rating standards would be able to evaluate the willingness and ability of a central government to repay its commercial financial debts as stipulated in contracts. The rating results could reflect the relative possibility of a central government to default as a debtor, and the rating is based on the country's overall credit value,

As the China's market economy develops and her joining WTO is getting closer, it is important for China to adopt international standards and conventions the soonest possible. As the new power of the information industry, Credit Rating came to being in China. A number of credit organizations in Beijing, Chongqing and Shanghai were created to meet market demand. The founding of those organizations were approved and supported by The People's Bank of China, State Administration for Industry and Commerce, State Administration of Taxation of China, provincial and municipal governments from all levels. The advancement in network technology will further propel the development of credit industry, evidencing China's entering into the Credit Economy era.

However, China's credit rating business is still in its initial stage, Rating agencies in China are not completely independent. "Many problems appeared 10 years ago, when China began to develop the industry and these problems still exist to some extent and some problems have become even worse. The rating criteria system is not standardized, the business scope is narrow, the law is outdated, the information is not available and the results of credit ratings are not fully used. False figures from clients also threaten the objectivity of the credit ratings due to slack management. The industry needs support from the government, because the whole credit system is a systematic work

Chinese rating agencies need to increase communication and cooperation on standardizing industry practice, perfecting rating techniques, improving credit rating standards and strengthening self-discipline.

With the financial crisis happening in the United States the credit rating agencies of china showed some matured stuff and was able to hold the Chinese economy stable in the financial crisis. Would the credit rating agency of India be able to withstand the financial crisis like the one happened in United States?

Brazil's Credit Rating

Brazil's stocks, bonds and currency are expected to continue to rise after Brazil received an investment grade credit rating for the first time, Standard & Poor's upgraded Brazil's credit rating one notch to BBB- from BB+, praising the debt reduction efforts, prudent spending and growth prospects of one of the world's top emerging economies. Analysts said the markets would rise because the upgrade increased the pool of investors who could buy the securities.

(Costa A)Analysts have welcomed the move as recognition of Brazil's increasingly solid fundamentals - including rapid economic growth and primary fiscal and trade surpluses - and one that will put the once-sleeping giant on the radar of a greater pool of investors and secure a steady flow of capital into the country. It's fiscal deterioration -characterized by rising spending, tax cuts, and a poor tax intake — will at the very least slow any upward movement in Brazil's credit rating,

The move shows the solidity of the Brazilian economy in an adverse global economic environment. It also proves that the country managed to go through the international financial crisis well; the investment grade will significantly made Brazil more attractive to foreign investors.

India‘sCredit rating

(Dr. Satija C K)The banking sector in India underwent an unprecedented transformation in the 1990s with the emergence of a large number of private as well as foreign multinational banks entering the country increasing rapidly the number of banks in India due to the economic reforms. Banks operate on the pattern of extending credit against security given by its customers associated with the bank. The facility of extending credit is recognition of the changing times in which banks have to operate in a changing and ever evolving economic scenario. Growing needs and realisation of higher rate of investments is giving birth to bank credit in India.

Thus for the need to increase the investment in the country. A need was felt to have a credit agencies maintaining database on the existing customers as in the absence of adequate and structured credit information for the banks and other credit providing agencies, there was always danger of a party obtaining financial accommodation from a large number of banks to an extent not warranted by his/her means or paying capacity, in such a case there is a chance having of bad debts (not retuning of credit) creating an added burden on the existing financial resources of banks. The functioning of the company formed under the Act is subject to the powers of Reserve Bank of India and cannot act in accordance with its own whims and wishes of the various Bank

In 1962, a Credit Information Division was established by Reserve Bank of India with the view of collecting of information from banks and other financial institutions regarding data relating to the prescribed limits sanctioned by RBI.

The RBI Act was amended in 1962 giving powers to collect information in regard to credit facilities granted by individual banks and notified financial institutions to their constituents and to supply to these banks and institutions on application the relative information in a consolidated form. Banks constantly kept a check on the customers by obtaining information from all the other sources pertaining to their customers in any form.

India's credit rating is facing growing pressure because of the widening fiscal deficit and the country's increasing dependence on foreign capital inflow, global rating agency The success of a credit information company depends on the credit market in a country or the penetration of credit in the market, for India it is huge because of the development in the industrial, housing and agricultural sector.

Credit Rating Agency in India is practiced by various agencies but the best and the most credible is the CRISIL Ratings. It is the fourth largest rating agency in the world. The issuers, investors, creditors always go through the ratings provided by this agency since it is the most comprehensible one. It is the best agency because it provides the most analytic information on the risk factors combining the science of risk building framework along with the understanding of the business situation in India.

There are five Credit rating agencies in India,


The concept of credit rating in India was initiated by the Credit Rating Information Services of India

Limited (CRISIL). It was established in 1987 and started operations in January 1988.

With over a 70% share of the Indian Ratings market, CRISIL Ratings is the agency of choice for issuers and investors. It is a full service rating agency that offers a comprehensive range of rating services and it also provides the most reliable opinions on risk by combining its understanding of risk and the science of building risk frameworks, with a contextual understanding of business.

CRISIL has rated over 6,797 debt instruments worth Rs.13.53 trillion (over USD343 billion) issued by over 4,600 debt issuers, including manufacturing companies, banks, financial institutions (FIs), state governments and municipal corporations.

2. ICRA:

ICRA Limited (formerly, Investment Information and Credit Rating Agency of India Limited) was incorporated on January 16, 1991 and launched its services on August 31, 1991, by leading financial/investment institutions, commercial banks and financial services companies as an independent and professional investment information and credit rating agency. ICRA is a public limited company with its shares listed on the Bombay Stock Exchange and National Stock Exchange. It is an independent and professional company providing investment information and credit rating services.

3. CARE:

Credit Analysis & Research Ltd. (CARE Ratings) established in 1993, is a full service rating company that offers a wide range of rating and grading services across sectors. It has completed over 3850 rating assignments having aggregate value of about Rs 8071 billion (as at December 2007), since its inception in April 1993. It has been recognized by statutory authorities and other agencies in India for rating services.

4. Duff & Phelps Credit Rating India Private Ltd. (DCR India):

Fitch Ratings India Private Limited, formerly known as Duff & Phelps Credit Rating India Private Ltd. prior to 2001, is a wholly-owned subsidiary of the Fitch group that started operating in India since 1996.


ONRICA Credit Rating Agency of India Limited was incorporated in 1993. It is a well-known player in the individual credit assessment and scoring services space in the Indian market. ONRICA is the first in India to launch commercial services and provide individual credit rating and reporting services to the Indian financial market.

Role of credit rating company in India

A credit rating company plays a major role in developing country as they need to rate the virgin market and the investors are not fully aware of the financial status of the particular debt. The investors are also risk neutral in nature and do not take huge risks as the economy is kind of unstable.

They need to build the market for corporate credit and the pricing of the credit with the help of using readily usable risk indicator, creating a proper yield curve.

THE CREDIT rating agency needs to reduce the information asymmetry between the investors and the issuers. They need to facilitate the comparison of investment options and pricing of credit risk.

They need to create liquidity in bond portfolios and make structured debt issuances easier. Also need to clarify the pricing of credit risk

And most importantly need to build financial awareness.

Issues needed to be looked at:-

1. Credit Rating quality:

The literature on India's credit rating industry is scanty. However, the few studies available point to the low and unsatisfactory quality. The literature on credit rating identifies lack of ‘unsolicited' rating as an important factor leading to poor quality of credit rating. In India all ratings are ‘solicited', i.e. all ratings are paid for by the rated entity. This creates a conflict of interest on the part of the rating agency since it is dependent on the fees of the rated entity for its business. Thus, credit rating industry in India is driven mostly by the rated entities. Under the present system, issuers of bond/debt instruments may go to any number of agencies for a rating of their bonds/debt instruments and have the right to accept or reject the rating. Further, the rating cannot be published unless accepted by the issuer.

2. Low penetration of Credit Rating:

The second important issue in India's credit rating industry is the low penetration of credit rating in India. A study in 1999 revealed that out of 9,640 borrowers enjoying fund-based working capital facilities from banks, only 300 were rated by major agencies. As far as individual investors are concerned, the level of confidence on credit rating in India is very low.

3. Issuer Ratings:

Presently credit rating in India is restricted to ‘issues' (the instruments) rather than to ‘issuers'. Ratings to issuers become important as the loans by corporate bodies and SMEs are to be weighted as per their ratings.

4. Effect of the Credit Rating scheme on Small and Medium Enterprises (SMEs) and Small Scale Industry (SSI) lending:

Besides agriculture and other social sectors, Small Scale Industry is treated as a

priority lending sector by RBI. SSI accounts for nearly 95 per cent of industrial units in India, 40 per cent of the total industrial production, 35 per cent of the total export and contributing about 7 per cent of the total GDP of India. In spite of its importance on Indian economy, SSI receives only about 10 per cent of bank credit. As banking reforms have progressed, credit to SSI has fallen. The SSI sector in India is so far out of the reach of the credit rating industry. This additional cost of credit rating is bound to affect the economic viability of a large number of SSI units. While introduction of credit rating for the SMEs (including SSIs) may, in the long run, perk up the accounting practices of the SSI, there is also a possibility that SMEs will continue to rely on the existing system of informal credit as formal credit is likely to become more expensive due to the credit rating requirement.

5. Barriers to entry and lack of competition

A new rating agency cannot obtain national recognition without NRSRO status and it cannot obtain NRSRO status without national recognition. Lack of competition in the industry has led to inflated prices, stifled innovation, lower quality of ratings, and unchecked conflict of interests and anti-competitive practices.

6. Potential conflict of interests

Conflict of interests may arise when a rating agency offers consulting or other advisory services to issuers it rates since issuers could be unduly pressured to purchase advisory services in return for an improved rating.

7. Transparency

Many market participants have expressed concern over the lack of transparency over CRAs' ratings methodologies, procedures, practices and processes. IOSCO requires the CRAs' methodologies to become public to enhance transparency in an industry which is very opaque in nature. the need to introduce some specific rules on fair representation which would establish a minimum level of disclosure on those elements and assumptions which make clear for market operators and investors to understand how a specific rating was determined by a credit rating agency.

8. Accountability

There is no apparatus to protect investors and/or borrowers from mistakes made by CRAs or any ill-treatment of power on their part. There remains the need for more formal regulation to address market failures in the form of imperfect competition and principal-agent problems in the credit rating industry.

Sometimes the regulation imposed on the Credit rating agencies becomes too much that its independence of ratings becomes questionable and destroys the basic purpose of its existence.

Credit rating agencies should be made accountable for the ratings given by them.

There even have been cases of Credit rating agencies manipulating the credit to increasing the volatility of capital flows from market leading to major financial crises. This is even done to force on certain portfolio managers to sell. The results of studies are not uniform leading to uniformity in the ratings of the Credit rating agencies.

Apart from these, also there are various issues related to the credit rating industry in India. The credit ratings are being institutionalized into the regulatory framework of banking supervision. This raises four important issues that need to be looked into. These are - the quality of credit rating in India, the level of penetration of credit rating, lack of issuer ratings in India and last but not the least, the effect of the credit rating scheme on Small and Medium Enterprises (SMEs) and Small Scale Industry (SSI) lending.

In India, the prime consideration is given to fund raising programme by hook or by crook.

And people in India have mastered the art of this.

Efforts to mobilise funds at the cost of investor's protection should be discouraged. This is the main rationale behind the development of credit rating agencies in India. It is the work of the credit rating agencies to evaluate the liquidity and safety of the company concerned and relay the necessary message to the interested parties.

Economic Conditions

America's Current Economic Condition

America today is burdened with deeply rooted and unsustainable economic challenges. From credit debts and loss of manufacturing nationwide, to foreign nations buying the best companies and propping up the economy with loans, these issues have impacted every citizen of the country

The major problems America faces today:

Wholesale sell-out of core strategic assets to foreign acquirers:

Subprime Fallout: more than one million home foreclosures have occurred in the first nine months of 2008 due to sub-prime lending.

Housing Bubble Burst: America's homes have hit their lowest value and sales rate while foreclosures soar.

Decline of vital industries through bankruptcy, foreign predatory competition, and foreign acquisition: Dependence on foreign financing of vast majority of government debt: foreign countries now control more than 44 percent of our total federal deficit and finance nearly 100 percent of all new borrowings. China, Japan, Great Britain and Saudi Arabia account for more than $2.3 trillion in loans. Japan holds around $517.2 billion while China holds nearly $405.5 billion in loans.

Outsourcing key manufacturing, research, and design: unchecked offshore outsourcing benefits individual companies and shareholders but destroys entire industries and communities

(Leonhardt David)In 2007, the American economy began to slow significantly, mostly because of a real-estate slump and related financial problems. In December 2007, the economy entered a recession, according to a committee of academic economists, overseen by the National Bureau of Economic Research that is widely considered the arbiter of recessions.

The bank cautioned that the recovery would be slow and that unemployment was likely to remain high for another year. In 2008, a series of bank and insurance company failures triggered a financial crisis that effectively halted global credit markets and required unprecedented government intervention.

The crisis has its roots in real estate and the subprime lending crisis. Commercial and residential properties saw their values increase precipitously in a real estate boom that began in the 1990s and increased uninterrupted for nearly a decade. Increases in housing prices coincided with a period of government deregulation that not only allowed unqualified buyers to take out mortgages but also helped blend the lines between traditional investment banks and mortgage lenders. Real estate loans were spread throughout the financial system in the form of CDOs and other complex derivatives in order to disperse risk; however, when home values failed to rise and home owners failed to keep up with their payments, banks were forced to acknowledge huge write downs and write offs on these products. These write downs found several institutions at the brink of insolvency with many being forced to raise capital or go bankrupt.

The 2008 financial crisis has exposed flaws in both the credit rating procedures and the incentives model for credit rating agencies. With the mortgage-backed securities created by investment banks, however, credit ratings agencies' ratings were off the mark as they assigned AAA ratings to what were by definition subprime and high risk loans. Ratings on these products were based on flawed mathematical models, which depended heavily on assumptions derived from historical data and the diversification of risk. With subprime loans and their pooled securities, however, very little data exists on which to make sound assumptions. As of July 2008, credit rating agencies had downgraded $1.9 trillion in mortgage backed securities to account for the lower repayment rates on subprime securities. Many of these securities were even downgraded to speculative grade ratings

Recent reports from Reuters have noted that US economic conditions are not exactly in good stead. This is worst depreciation of US economy after 1982 as per financial reports of fourth quarter of 2008 fiscal. Much of present economic conditions of US could be blamed on exports that have been falling steadily. In US consumers have restricted their expenditures. Both these factors have played a significant role in sordid economic conditions in US.

According to latest information on economic conditions at US national economy depreciated at a rate of 6.2 percent for 2008 fiscal. During January 2009 it had been calculated by Commerce Department that in final quarter of 2008 economy of US depreciated at a rate of 3.8 percent. In latest information on economic conditions in America it has been seen that stock markets in US have been hit hard by global economic downturn. This has been indicated by its various stock indices like Dow Jones Industrial Average for example that have declined at an alarmingly sharp rate. US economic conditions have been affected further by declining levels of consumer expenditures.

(Farrakhan Louis)Asia, Africa and Latin America have been the playground for America's economic and leisure purposes. Now that America's ability to extract raw materials from these countries and compete against their products in the global economy has declined, America's standard of living is on the decline. When the door to the raw materials of Asia, Africa and Latin America closes to imperialistic design, the standard of living in America will decline. Those doors are now closing, and the American people are beginning to suffer as a result. Consequently, America buys more from foreign countries, particularly Japan and Eastern Europe, than she sells to foreign countries. The door to the world is closing and America is not competing well in the global economy. Thus the American standard of living is going down

United Kingdom'sEconomic Conditions

During the days of the British Empire the UK economy was the largest in the world and the first to industrialise (or industrialize, ushering in the Industrial Revolution). Although it has declined in significance since then, but it is still the sixth largest economy in the world by purchasing power parity. The British Economy is one of the most globalised (or globalized) economies in the world, thanks in no small part to the City of London, considered to be the largest financial centre in the world.

The economy of the United Kingdom of Great Britain includes the economies of England, Scotland, Wales and Northern Ireland. The Isle of Man and the Channel Isles are part of the British Isles and have offshore banking status.

According to latest reports on United Kingdom economic conditions a major aim behind this move is to generate money that is substantial enough for purposes like bettering balance sheets as well as doing away with losses and write offs incurred on a short term basis. Latest news on UK economic conditions reports that UK government is facing a tough situation trying to balance its domestic unemployment, levels of which are rising on a steady basis, and its liberal business policies with regards to immigration. As per latest macroeconomic indicators in UK national economy of United Kingdom shrank at a rate of 1.5 percent in final quarter of fiscal 2008.

It was the 2nd largest recipient of foreign direct investment (FDI) in 2007 (although the figure has dropped since), and one of the most competitive in Europe for business and tax. The British economy in 2009 was declining at an even quicker rate than originally suspected. The Bank of England had cut interest rates to 1.0 per cent by the end of 2008, and that is expected to drop to 0.5 per cent for most of 2009 and 2010. UK budget deficit stood at 5.3 per cent of GDP in 2008. Inflation had ramped up to 3.6 per cent in 2008, but has dropped back with the economic collapse

The unemployment rate had reached 6.3 per cent in the UK by the end of 2008 according to the Office of National Statistics, reaching close to 2 million unemployed.

(Kollewe Julia)THE ECONOMIC SITUATION Inflation is accelerating worldwide, with Britain in the lead. For the seven largest industrial countries as a group the rate is expected to rise from about 3 per cent last year to about 4-1/2 per cent this year. The main reason is the increase in the pressure of demand, which has raised commodity prices, and which has resulted in the highest level of output relative to capacity since 1973. Most countries, the UK in particular, have responded by raising interest rates, which will slow down growth rates this year and next. Overall, following a sharp contraction over the winter and spring, the UK economy appears to be stabilising at GDP levels similar to those of early 2006, but it is not yet on a solid recovery path."

(Hyde Deborah)some people have overestimated the amount of money the government has handed over to the banks. The actual cost of the bailout may come down as assets are sold and the insurance policy for bad loans pays out less than some fear.

China's Economic Conditions

Since the initiation of economic reforms in 1979, China has become one of the worlds fastest-growing economies. From 1979 to 2005 China's real GDP grew at an average annual rate of 9.6%. Many economists speculate that China could become the worlds largest economy at some point in the near future, provided that the government is able to continue and deepen economic reforms, particularly in regard to its inefficient state owned enterprises (SOEs) and the state banking system. In addition, China faces several other difficult challenges, such as pollution and growing income inequality that threaten social stability.

Prior to 1979, China maintained a centrally planned, or command, economy. A large share of the country's economic output was directed and controlled by the state, which set production goals, controlled prices, and allocated resources throughout most of the economy. Private enterprises and foreign-invested firms were nearly nonexistent. A central goal of the Chinese government was to make China's economy relatively self-sufficient. Foreign trade was generally limited to obtaining only those goods that could not be made or obtained in China.

(Wayne M. Morrison)China has historically maintained a high rate of savings. When reforms were initiated in 1979, domestic savings as a percentage of GDP stood at 32%.savings as a percentage of GDP has steadily risen; it reached 49% in 2004, among the highest savings rates in the world China's abundance of cheap labour has made it internationally competitive in many low-cost, labour-intensive manufactures. As a result, manufactured products constitute an increasingly larger share of China's trade.

Since the initiation of economic reforms, beginning in 1978, China has become one of the world's fastest growing economies. Over the past 10 years, China's GDP has grown at an average annual rate of nearly 10%. Some economists have speculated that China could become the world's largest economy at some point in the near future.

From 1979 to 2008 Chinas real gross domestic product (GDP) grew at an average annual rate of nearly 10%; it grew 13% in 2007 (the fastest annual growth since 1994). However, the current global economic crisis has hit China hard real GDP growth slowed to 9% in 2008, and many analysts predict the economy will slow even more sharply in 2009.

In 2008, foreign direct investment (FDI) in China totalled $92 billion, making it the third largest global destination for FDI. The combination of large trade surpluses, FDI flows, and large-scale purchases of foreign currency have helped make China the world's largest holder of foreign exchange reserves at $1.9 trillion at the end 2008. The global financial crisis is having a significant impact on Chinas trade, as exports and imports in November and December 2008 and January 2009 declined on a year-on-year basis. FDI flows have also declined sharply during this period.

China is now the world's third-largest trading economy after the United States and Germany. China's trade boom is largely the result of large inflows of foreign direct investment (FDI) into China. China economic conditions have revealed that in 2008 fiscal Chinese economy grew at a rate of 9 percent. This was lower than in fiscal 2007 when rate of growth was 13 percent. Rate of economic growth in last quarter of 2008 fiscal was 6.8 percent.

Government policies kept the Chinese economy relatively stagnant and inefficient,

mainly because there were few profit incentives for firms and farmers; competition was

virtually nonexistent, and price and production controls caused widespread distortions in the economy. Chinese living standards were substantially lower than those of many other developing countries. The Chinese government hoped that gradual reform would

significantly increase economic growth and raise living standards.

The banking system faces several major difficulties due to its financial support of SOEs and its failure to operate solely on market-based principles. China's banking system is regulated and controlled by the central government, which sets interest rates and attempts to allocate credit to certain Chinese firms. The central government has used the banking system to keep afloat money-losing SOEs by pressuring state banks to provide low interest loans, without which a large number of the SOEs would likely go bankrupt. The high volume of dire loans now held by Chinese banks poses a serious threat to China's banking system. Three out of the four state commercial banks are believed to be insolvent. The precarious financial state of the Chinese banking system has made Chinese reformers reluctant to open the banking sector to foreign competition. Corruption poses another problem for China's banking system because loans are often made on the basis of political connections.

China's rise as an economic superpower is likely to pose both opportunities and challenges for the United States and the world trading system. China's rapid economic growth has boosted incomes and is making China a huge market for a variety of goods and services. In addition, China's abundant low-cost labour has led multinational corporations to shift their export-oriented, labour-intensive manufacturing facilities to China. This process has lowered prices for consumers, boosting their purchasing power. It has also lowered costs for firms that import and use Chinese-made components and parts to produce manufactured goods, boosting their competitiveness. Conversely, China's role as a major international manufacturer has raised a number of concerns. Many developing countries worry that growing FDI in China is coming at the expense of FDI in their country. Policymakers in both developing and developed countries have expressed concern over the loss of domestic manufacturing jobs that have shifted to China

The current economic and financial crisis in Asia has begun to affect the Chinese economy. Chinese officials have raised concerns that the devaluation of several Asian currencies (including the Japanese yen) is making many Chinese exports less competitive in international markets. U.S. officials have urged China not to devalue its currency out of concern that it could lead to a new round of currency devaluations in Asia and further deepen the financial crisis there. The Asian financial crisis could affect the pace and extent of future Chinese economic reforms.

Latest reports on economic conditions of China have confirmed that this Asian nation has adopted an approach of open trading to address economic imbalances. It has been encouraging local companies to conduct business with their European counterparts. Economic conditions at China and reports regarding same suggest that Chinese economy has been recovering from tremors of global economic catastrophe. However, there are still some effects of ongoing economic crunch.

Brazil's Economic Condition

The Brazilian economy is bouncing back, but is the recovery here to stay? Brazil's economic recovery is now well under way. Following a few years of unimpressive growth, the economy has bounced back more strongly than anticipated, with GDP growth of more than 5% in 2004, the fastest expansion in 10 years.

To be sure, the economy appears to have become more resilient to external shocks. Until now, a reliance on foreign financing has tended to make Brazil vulnerable to changes in global market sentiment. But record trade and current account surpluses emerged in 2004 on the back of robust export growth rather than a fall in imports. Importantly, the maintenance of a freely floating exchange rate has been essential in making the economy more responsive to external price signals.

The recovery is not merely linked to the upswing in the current economic cycle. It also means the country is better equipped to withstand sudden reversals in international financial conditions,

Brazil's track record in meeting annual budget targets has improved, even under difficult economic conditions. The monetary front, the central bank is committed to targeting as a way of bringing about low and stable inflation in the long run. This should lead over time to lower interest rates-which in Brazil are high at over 10% in real terms-and stronger private investment. A further boost to confidence in the institutional set-up would come if legal operational autonomy were granted to the central bank.

Brazil's growth performance has been erratic in recent years but the foundations for a sustained recovery appear to be broadly in place. It's economy generates twice the value of products and services as Russia, accounts for over half of Latin American output (whose consumers and firms buy 20% of U.S. exports, totally about 115 billion dollars), and has the potential to do significant damage to the earnings of many American firms, if the current crisis results in a collapse in corporate and household spending in Brazil. This latter scenario seems, at the moment, a distinct possibility.

The well heeled in Rio and Sao Paolo became convinced that devaluation of the real was inevitable and began shifting their wealth out of Brazil and into bank and brokerage accounts in the U.S., Europe, and off-shore havens. The more dollars fled Brazil, the more negative expectations about Brazil's future, particularly the future value of the real. The more negative the expectations, the more the capital flight.

In an effort to defend the real, the Brazilian Central Bank pushed up interest rates to nearly 50%. The high interest rates raised the cost of servicing debt, both public and private debt, to levels that were so high that investors became even more certain that a major default would occur, followed by a subsequent collapse in the dollar value of the real. Thus, the high interest rates did not stem the tide of dollars flowing out of Brazil. Indeed, the high interest rates only speeded up the fall in asset prices in the Brazilian economy, reducing the collateral backing existing loans, increasing the rate and risk of bankruptcies, and placing extraordinary burdens on the entire financial system.

The 9% devaluation in the real/dollar exchange rate not only did not stop the bleeding of dollars out of Brazil but speeded it up. The Sao Paolo Stock Exchange plunged 10% on the day of the devaluation triggering a limit down halt to trading. The next day the Exchange went limit down again, closing down 9.97%. As happened in Mexico in December of 1994, the domestic rich preceded the foreigners in heading for the exits.

(Gabriel Satya)To make matters worse, credit agencies, who were criticized for being too slow to reassess the Asian economies, are now downgrading Brazil's sovereign debt. This will further raise borrowing costs and create even tighter credit conditions for the entire Brazilian economy. The devaluation will raise the costs of imported inputs to industry, as well as imported consumer goods.

Given the stronger than expected numbers the sovereign should easily meet its IMF prescribed target of 3.35% of GDP for 2001 - in fact on a 12-month trailing basis, the surplus now stands at 4% of GDP.

Exports, which account for less than 10% of the GDP, are still vital to the country as it is the earned surplus that makes it possible to pay the interest on the enormous Brazilian foreign debt. Despite the country's great potential (it is the largest producer of coffee and citrus fruit in the World and the second largest producer of soya1, cocoa, sugar and cattle); millions of inhabitants working in rural areas live in extreme poverty.

The worst of the 2008 international financial crisis proved that Brazil was more prepared than ever for a traumatic economic situation; Compared with similar turmoil's in the past, Brazil had survived the latest crisis with more than reasonable reserves (210 billion U.S. dollars), a controlled inflation rate and a GDP growth of 6.8percent. Brazil's industrial production fell 20 percent in the last four months of 2008, and increased 7.9 percent from Dec. 2008 to June 2009

India's Economic Condition

India, a land of rich culture, is the second most populous country of the world. And area wise, it is the seventh largest nation. The Indian economy has undergone a tremendous change, with the implementation of a series of economic reforms. These reforms focused attention on deregulating the country and inducing foreign investments. Eventually, it paved way for India occupying a position among the top countries in the fast growing Asia Pacific region.

When the talk is about the economy of India, it can be undoubtedly said that it provides a complete security to its foreign investors. It promotes a transparent environment that includes a free press and a proper legal and accounting system. India has a competitive and dynamic private sector that forms the backbone of India's economic activities. It also accounts for more than 75% of India's Gross Domestic Product.

The rate of growth improved in the 1980s. From FY 1980 to FY 1989, the economy grew at an annual rate of 5.5 percent, or 3.3 percent on a per capita basis. Industry grew at an annual rate of 6.6 percent and agriculture at a rate of 3.6 percent. A high rate of investment was a major factor in improved economic growth. Investment went from about 19 percent of GDP in the early 1970s to nearly 25 percent in the early 1980s.

Private savings financed most of India's investment, but by the mid-1980s further growth in private savings was difficult because they were already at quite a high level. As a result, during the late 1980s India relied increasingly on borrowing from foreign sources. This trend led to a balance of payments crisis in 1990; in order to receive new loans, the government had no choice but to agree to further measures of economic liberalization. This commitment to economic reform was reaffirmed by the government that came to power in June 1991.

Since 1990, the economy of India has witnessed a decent growth rate of 6% and has been successful in overcoming poverty by about 10%. The strength of India lies in its vast pool of educated and skilled citizens. But, the weakness of India is the continuing public-sector budget deficit, which is nearly 10% of GDP.

India is one of world's fastest growing economies. Apart from China, no other country has as high an economic growth rate as India. India's economic boom has been made possible mainly through its information technology and outsourcing business.

India GDP (purchasing power parity) stood at around $2965 billion, as per CIA's 2007 estimates, of which services accounted for maximum percentage, followed by industry and agriculture. As per CIA estimates, total Indian exports totalled $140.8 billion and total imports totalled about $224 billion.

Inflation in India rose to more than 11 percent in July 2008. But due to government measures and role played Reserve Bank of India, inflation was brought down to about 6 percent. Earlier in 2007, average inflation was around 5.3 percent. In 2007-08, foreign direct investment in India touched $25 billion. In previous time period, this figure was around $15.7 billion. As of May 21, 2008 India's foreign exchange exceeded $341 billion. Ministry of Commerce and Industry projections indicate that India is slated to attract more than $35 billion as foreign direct investment. Ernst and Young had carried out a survey in June 2008, which identified India as fourth most attractive investment destination of world. All this augurs well for economic condition of India.

India has been one of the best performers in the world economy in recent years, but rapidly rising inflation and the complexities of running the world's biggest democracy are proving challenging. India's economy has been one of the stars of global economics in recent years, growing 9.2% in 2007 and 9.6% in 2006. Growth had been supported by markets reforms, huge inflows of FDI, rising foreign exchange reserves, both an IT and real estate boom, and a flourishing capital market.

Like most of the world, however, India is facing testing economic times in 2008. The Reserve Bank of India had set an inflation target of 4%, but by the middle of the year it was running at 11%, the highest level seen for a decade. The Indian stock market has fallen more than 40% in six months from its January 2008 high. $6b of foreign funds has flowed out of the country in that period, reacting both to slowing economic growth and perceptions that the market was over-valued.

It is not all doom and gloom, however. A growing number of investors feel that the market may now be undervalued and are seeing this as a buying opportunity. If their optimism about the long term health of the Indian economy is correct, then this will be a needed correction rather than a downtrend.

India's Economy has grown by more than 9% for three years running, and has seen a decade of 7%+ growth. This has reduced poverty by 10%, but with 60% of India's 1.1 billion populations living off agriculture and with droughts and floods increasing, poverty alleviation is still a major challenge.

Illegal Money

The literature on “flight capital” is rich and varied but far from thorough or complete. The term flight capital is most commonly applied in reference to money that shifts out of developing countries, usually into western economies. Motivations for such shifts are usually regarded as portfolio diversification or fears of political or economic instability or fears of taxation or inflation or confiscation. All of these are valid explanations for the phenomenon, yet the most common motivation appears to be, instead, a desire for the hidden accumulation of wealth.

Flight capital takes two forms—legal and illegal. Legal flight capital is calculated in the Hot Money Method of analysis as portfolio investment and other short-term investments, but not including longer-term foreign direct investment. Legal flight capital is recorded on the books of the entity or individual making the transfer, and earnings from interest, dividends, and realized capital gains normally return to the country of origin. Illegal flight capital is intended to disappear from any record in the country of origin, and earnings on the stock of illegal flight capital outside of a country do not normally return to the country of origin. Illegal flight capital can be generated through a number of means that are not revealed in national accounts or balance of payments figures, including trade mispricing, bulk cash movements, hawala transactions, smuggling, and more. We argue that by far the greater part of unrecorded flows are indeed illicit, violating the national criminal and civil codes, tax laws, customs regulations, VAT assessments, exchange control requirements and banking regulations of the countries out of which unrecorded/illicit flows occur.

Illegal money worldwide

Illicit financial flows in the context of this report includes the proceeds from both illicit activities such as corruption (bribery and embezzlement of national wealth), criminal activity, and the proceeds of licit business that become illicit when transported across borders in contravention of applicable laws and regulatory frameworks (most commonly in order to evade payment of taxes).

Official statistics on illicit financial flows do not exist because these outflows escape the detection of regulatory agencies. Some facts about the outflows of illicit capital:-

  1. In 2006, the most recent year of the GFI study, developing countries lost an estimated $858.6 billion $1.06 trillion in illicit financial outflows.
  2. Even at the lower end of the range of estimates, the volume of illicit financial flows coming out of developing countries increased at a compound rate of 18.2 percent over the 5 year period analyzed for the study.
  3. On average, for the five-year period of this study, Asia accounts for approximately 50 percent of overall illicit financial flows from all developing countries.
  4. Due to a large volume of illicit financial flows from mainland China, Asia was the dominant region in overall illicit financial flows from developing countries.
  5. On average, Europe ranks second in the share of overall illicit financial flows from developing countries accounting for approximately 17 percent of the total.
  6. The share of illicit financial flows from the Middle East and North Africa (MENA) region and the Western Hemisphere region are each approximately 15 percent of total illicit financial flows from developing countries.
  7. The smallest share of illicit financial flows is from the Africa region at approximately 3 percent of the total. However, there are strong reasons to believe that the share would have been higher if more complete and reliable data were available.

Black money in India

The black sector emerged in India during World War II, when daily necessities were in acute scarcity and the government of the day adopted rationing as a welfare policy, thus introducing a system of controls. With prices no longer set by the natural interaction of market demand and supply, black marketing—the surreptitious sale of diverted goods at higher prices—emerged.

India has more money in Swiss banks than all the other countries combined. With personal account deposit bank of $1,500 billion in foreign reserve which have been
misappropriated, an amount 13 times larger than the country's foreign debt, one needs to rethink if India is a poor country?

DISHONEST INDUSTRIALISTS, scandalous politicians and corrupt IAS, IRS, IPS officers have deposited in foreign banks in their illegal personal accounts a sum of about $1500 billion, which have been misappropriated by them. This amount is about 13 times larger than the country's foreign debt. With this amount 45 crore poor people can get Rs 1, 00,000 each.

This huge amount has been appropriated from the people of India by exploiting and betraying them. Once this huge amount of black money and property comes back to India, the entire foreign debt can be repaid in 24 hours. After paying the entire foreign debt, we will have surplus amount, almost 12 times larger than the foreign debt. If this surplus amount is invested in earning interest, the amount of interest will be more than the annual budget of the Central government. So even if all the taxes are abolished, then also the Central government will be able to maintain the country very comfortably.

The list is almost all-encompassing. No wonder, everyone in India loots with impunity and without any fear. What is even more depressing in that this ill-gotten wealth of ours has been stashed away abroad into secret bank accounts located in some of the world's best known tax havens. And to that extent the Indian economy has been stripped of its wealth. Ordinary Indians may not be exactly aware of how such secret accounts operate and what are the rules and regulations that
go on to govern such tax havens.

While India reports a nearly 6 per cent growth in the economy, its underground economy, or black economy, also seems to be thriving. Quoting various studies done in the past, the Indira Gandhi Institute of Development Research (IGIDR) estimates that India's black economy is around 18-21 per cent of the GDP (gross domestic product).

However, tax evasion accounts for only part of the black economy. The IGIDR study says black income is generated from illegal activities that are harmful to society such as smuggling, trafficking in illicit drugs, pornography and gambling. But there are other apparently harmless illegal activities too such as "moonlighting (e.g. private tuition by salaried teachers and private practices by publicly employed doctors).

Compared to the rest of the globe which appears on the verge of collapse, the Indian economy is doing pretty well indeed, thanks mainly to the abundance of black money in the country. The parallel economy n fact, now be doing a rescue act for the country's troubled $1-trillion economy. As the economy is slowing down, after three years of 9 per cent plus growth, there are indications that black money is sustaining economic activities. Sectors ranging from real estate to road transport have a huge black money element, and this is what is keeping them going in these “bad” times. However, it is possible that in times of economic downturns like these, the parallel black economy gets a boost and, in fact, helps absorb some of the shocks RBI has no firm estimates but, according to this official, cash transactions are growing by over 30 per cent and these are keeping both domestic and foreign trade channels brimming with activity.

(Dash R P)But as the IGIDR study pointed out the black economy could have other benefits for the normal economy. Even if returns from black investment go unaccounted for in the national accounts, they may trickle down to improve the overall standard of living in the country.

Parallel Economy

Black is the colour of the other Indian economy. Black or the parallel economy is the undercover economy. It is an open secret. Nobody denies its existence, everybody acknowledges its existence, yet all are at a loss on how to tame it. Contrary to popular belief, the black economy not rooted only in smuggling. It encompasses all sorts of pilferage, adulteration and evasion. It connotes the functioning of an unsanctioned sector in the economy whose objectives run parallel, rather in contradiction with the aroused social objectives.

A parallel economy is also known as an underground economy. It is a type of market where many of the rules of taxation and trade are not adhered to. It is also referred to as underdog, black market, shadow economy and black economy.

Much of a black market is legal business being conducted in an effort to evade tax authorities. The money that changes hands in such an economy are never recorded and no taxes are ever paid.

India's parallel economy is so deeply entrenched that possession of black money is not even considered worthy of reproach in social reckoning. In fact, custodians of the administrative machinery themselves seem to have joined the race to accumulate such wealth.

The black economy in India is gaining in prominence by the day. Much of this could be attributed to the negligent attitude of the concerned authorities. Over the years, black economy has had substantial impact on the size of the Indian economy. The high rates of inflation and taxation in India has been a result of the increasing powers and activities of the black economy.

Black money or unaccounted money circulating in the parallel economy is a big menace to the economy. It is also a cause of big loss in the tax-revenues for the government. As such it needs to be curbed.

(Deepak)it is the parallel economy which does the backseat driving, while the political leadership only acts as the mouth-piece of big business to justify the abolition of controls or introduction of a dual system of prices in the name of productivity or national interests.

Due to globalisation one country's economical conditions affect others. An economy is less effected when it is strong from inside but it was not the case for India; existence of parallel economy, black money, fake currency problem, political crisis, high population and high unemployment rate acted as catalysts. In this era of globalisation a high volume of illegitimate commercial and financial transactions are going on. Banking and investment institutions of US and European countries are being flooded with this type of illegitimate activities.

According to Feige when economic activities goes unreported or not measured by societies current techniques to monitor economic activity it falls under parallel or hidden economy

In case of underground economies of US, UK and Germany, people in order to get government benefits tries to indulge in social security frauds. When parallel economy exists government does not get the actual amount it should get from the tax payers and the actual GDP falls and it will increase fiscal deposit of the country.


3.1 Source Data

First of all, I obtained the monthly data of interest rate swap rates and constant maturity Treasury rates with maturity of 2, 5, 7 and 10 years from Datastream and Ecowin in order to examine the behaviour of determinants of interest rate swap spread empirically. At the same time, I obtained 90-day Treasury rates, double A and triple A corporate bond rates from Ecowin. Due to the data limitations, there are only a total of 106 observations from the sample period starting from June 30, 1998 to March 31, 2007. Secondly, I determine the interest rate swap spread by taking the difference between interest rate swap rate and the constant maturity Treasury rates of the same maturity. In Figure 1 and 3, I plot the movement of interest rate swap rates and interest rate swap spreads for all maturities. The slope of the yield curve is calculated as the difference between 10-year Treasury rate and 90-day constant maturity Treasury rate. I use the unemployment rate as proxy for the variation of business cycle. The difference between double A and triple A corporate bond rates used as the proxy of default premium. Finally, the implied volatility of Equity market and Treasury market are obtained by calculating the daily observations of S&P 500.

Figure 1 shows the swap rates of 2-, 5-, 7- and 10-year maturity during the period of June 1998 to December 2006, which represents the short, medium and long term swap rates, respectively. As the graph shows, swap rates have climbed up since December 1998. Short-term swap rates peaked up to long-term swap rates while the short-term yield curve moved above the long-term yield curve during December 1999 to February 2001 showed by the graph in Figure 2. From March 2001 to September 2005, the short-term swap rates have generally declined; the short-term swap rate move along the same direction as yield curves. Hence, it is very clear that the swap rates vary with the changes in yield curves of Treasury bonds.

3.2 Interest rate swap spread

Interest rate swap spread is determined by the difference between swap rate and Treasury rate of same constant maturity. In my thesis paper, I defined swap rate as the fixed rate of interest that makes the value of the swap equal to zero at the contract date

Figure 4 shows the movements of swap spreads of 2-, 5- 7-, and 10-year maturity during the chosen sample period. It is clearly shown that the movements in short, medium and long term maturities have tendency to move together all the time. However, I it is observed that there is a peak at the end of 90s and beginning of 2000. The explanation could be that the financial crisis in 1998 might imply both a default risk event and a liquidity event.

3.3 Explanatory variables

Changes in slope of the yield curve. Based on the previous research results, there is a need for variables that can summarize the information in the Treasury Securities yields. In line with those research results, I included the slope of yield curve into my model and defined the slope of the yield curve as the difference between 10-year and 90-day Treasury securities yields. Besides the expected contributions to variation of swap spreads, this proxy variable is also interpreted as an indication of expected future short-term interest rate as well as an indication of overall economic health.

Changes in implied volatility of Treasury market. There is strongly close correlation between swap rates and government bond yields over long-term maturity based on economic theory. I believe the volatility in Treasury market have impact on movement of swap spreads. To better integrate this variable into swap spread investigation, I use the implied volatility as a proxy of the volatility of Treasury market. The implied volatility of an option contract is the volatility implied by the market price of the option based on an option-pricing model. More specifically, the volatility, given a particular pricing model such as Black-Shole model, yields a theoretical value for the option equal to the current market price. This allows some non-option financial instruments such as Treasury bonds having embedded optional, to also have an implied volatility.

Changes in default premium. Even though the default premium has been considered the basic determinant factor on variation of swap spread, there are no strong statistically consistent empirical evidence on the relationship between default risk premium and swap spread changes has not been proved even though. However, I would still like to include this variable into my model. The standard way is to assume that default risk in swaps can be precisely proxied with the information from the corporate bond market as noted by Milas (2001). In my paper, I define the default premium as the difference between double A and triple A corporate bond yields of same constant maturities.

Changes in implied volatility of Stock market. Similar rationale as above discussion, I need a variable which can catch the information in stock market. Theoretically, there is negative co-movement between the default probability and the stock price. Therefore, I include the volatility in the stock market has its role in the swap spread changes.

I obtain this proxy variable by calculating the standard deviation of the daily observations from S&P 500, the theoretically rationale of using implied volatility is similar to that of implied volatility of Treasury market as explained above. Furthermore, since the value of the option increases with the volatility, it implies that the swap spread should increase with the volatility as well. On the other hand, an increased volatility implies that the probability of default increases as well.

Changes in Budget Deficit. There is only a limited study on this variable as a determinant risk factor on swap spread. The reason I want to include this variable into our model is the issuance of government bond increases with the increases in government budget deficit based on the economic theory,. Therefore, I consider that the Treasury rates might climb up or decline due to the demand/supply shock in Treasury bond market. Accordingly, I predict that a change in swap spread is related to the change in budget deficit. In my paper, I define this explanatory variable by using the monthly government budget deficit index.

Changes in Business Cycle. Lizenberger (1992) argued that default risk allocation between swap counterparties varies with the business cycle; hence this variable should be controlled while testing the impact of default risk on swap spread. However, he did not show how exactly default risk allocation varies with business cycle. Furthermore, there are really limited researches regarding to this variable. These questions motivate me to include this variable into my model. In this paper, I use U.S monthly unemployment rate as a proxy viable for business cycle.

Misuse of swaps in India

A. Using Rate Swaps In Gap Management

Different institutional requirements and different market conditions have resulted in distinctly different compositions of balance sheets for depository institutions in the U.S. and abroad. For instance, many U.S. financial institutions have assets the returns of which are denominated in fixed rates of interest, with relatively long maturities (e.g., mortgage and consumer instalment loans) and liabilities with relatively short maturities (e.g., money market deposit accounts and variable-rate certificates of deposit) which are reprised frequently. On the other hand, some typical European financial institutions have assets with relatively short maturities and liabilities with relatively long maturities. These differences in inter-firm asset/liability composition represent opposite kinds of gaps in balance sheets. Interest rate swaps provide an economic mechanism whereby both financial institutions can benefit from a reduction in their respective balance-sheet gaps and a decrease of exposure to interest-rate risks.

B. Using Rate Swaps To Lower Fixed-Rate Cost

Interest rate swaps can be a very useful tool for lowering a company's cost of long-term fixed interest rate borrowing. It has particular appeal for a company with a relatively low credit rating. In both floating-rate and fixed-rate markets, a borrower with lower credit rating has to pay a quality spread over what a borrower with a higher credit rating has to pay. However, the quality spreads in the long-term fixed-rate markets and that in the short-term floating-rate markets are not necessarily identical

The difference in the quality spreads presents a market arbitrage opportunity via the emergence of the interest rate swap market. The technique of fixed/floating rate swap was indeed developed in order to take advantage of the differential quality spreads between the long-term corporate bond market and the short-term credit market.

C. Using Rate Swaps To Restructure Debt Mix

Interest swaps are a useful tool for active liability management. Financial managers can use interest rate swaps to change the debt mix of a firm.

D. Using Swaps To Manage Basis Risk

Interest rate swaps can also be used as an effective tool for financial institutions to manage the basis risk in the balance sheets.

Executive Summary

This research revolves around the feasibility of swaps in developing countries especially India. How the introduction of swap instrument would affect the economy.

India a developing nation where the economy has not even fully matured and where the investors are also risk neutral in nature and do not take huge risks as the economy is kind of unstable.

With a rough estimated $1,500 billion of black money in Swiss Banks and corruption and its highest level, the introduction of swap won't be a good idea as the credit rating agencies haven't fully matured and the economy is unstable.

The common man running a parallel economy in order to invade tax and bribing the government officials for every work they have with them. The credit rating agency would then become a soft target and companies and people could get a better rating even if they don't deserve it and which could further result in another recession.

Developed countries like America , United Kingdom where the amounts of black money and corruption are quite low could face such a problem then why not India where these amounts are at the highest level.

Also comparing the economic conditions of developed countries, under developed countries with the Indian economy which is being developed , the amount of Foreign Direct Investment (FDI's ) in India is a small amount as compared to its counterparts, this is mainly due to the policies of the Indian government.

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/swap-derivative.php

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