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2

draft, a loan, a bond, a bill, a note.

30 The five financial building blocks

banks and market forces. This means that interest rates change over time and

so floating interest rates can rise and fall over the period of a loan.

The ultimate source of debt finance is individuals and companies who

want to invest but who do not want to take risk. Where does this money come

from? Well, it can come from many sources. Think, for example, about money

set aside to pay your future pension. Most people would want to be sure that at

least a part of their pension was absolutely secure. Think also about short term

saving which you might make for a particular big purchase which you antici-

pate making as soon as you can afford it. Again, it is likely that you would

want to accumulate the money without being subject to the risk of losing it.

As a result of structural factors such as this there is a huge potential supply of

money available to those who can offer risk free investments.

Banks and other financial institutions act as the middle men between

those who want to invest without taking risk and those who want to bor-

row. Banks will devote a lot of attention to understanding what is termed the

creditworthiness of the companies and individuals that they lend to. Banks

will also attempt to do everything they can to minimise the risks that they

take. For example, they will reserve the right to take possession of your house

if you fail to repay your mortgage.3

For the remainder of this section we will look into various aspects of debt

in a little more detail. The aim is to paint the picture of debt that it is a con-

venient and highly flexible source of finance that can be tailored to the spe-

cific needs of borrowers or lenders thanks to the workings of the financial

markets.

How to value debt

Debt is something that can be bought and sold. So banks can and do on-sell

their rights to loans. The value of a loan can be calculated using the economic

value model.4

Let us consider the example of a two year loan with interest at 4%. So if

you borrow $100 you would pay $4 of interest at the end of the first year and

then a further $4 of interest at the end of the second year along with the $100

The so-called subp me mo g ge crisis which hit the USA in 2007 was a consequence of lenders pa -

e l d subprime mortgage s s ich it he n 07 s o quen e pay-

3

ing insufficient attention to downside risk and making loans which may well not be repaid in full even

if houses are repossessed.

The origins of the economic value model lie in the fact that debt is valued this way. The logic is that

4

something which works for debt should also work for other riskier investments but should simply

offer a greater return in order to make it worthwhile taking the extra risk.

31 Building block 2: Financial markets

original principal. The cash flows are $4 after one year and $104 after two. If

the discount rate is 4% then the present value of the payments is exactly $100.

Now suppose that interest rates fell to 3% immediately after the loan was

made and that the loan was at a fixed interest rate. The payments to be made

will remain as $4 and then $104. If these are discounted to the present at 3%

we can calculate the present value of the payments as $101.9.5 So from the

perspective of the lender, the debt will have risen in value by $1.9 as a result

of the fall in interest rates. Had interest rates risen then the value of a loan

would have fallen.6

The implication of this valuation method is that floating rate debt will

trade â€˜at parâ€™. That is to say, it should always be worth its face value.7 This is

because it will always be discounted at the prevailing interest rate. Hence a

loan of $100 can always be sold for $100. By contrast, fixed rate debt will rise

and fall in value as interest rates go down and up.

Fixed or floating rate?

The interest rate is one of the key levers that can be used to control an econ-

omy.8 Governments and/or central banks have various means at their disposal

to control interest rates and the announcement of, say, a quarter percent rise

or fall in the rate is quite common. So, which is best for borrowers or lenders,

fixed or floating? Clearly, if either has a reliable crystal ball that will indicate

the future direction of interest rates then this should be followed. But what

should those who are not clairvoyant do?

The answer depends on the circumstances of the individual or company

concerned. To explain why, we need go back to our understanding of the

purpose of debt and how it is valued. The purpose of debt from a lenderâ€™s

perspective is that it should be low or no risk. Now we need to think about

exactly what this means.

The calculation is best done, in my view, by starting with the final year cash flow of $104. Discount this

5

by one year by dividing by 1.03. This gives $100.97. The $4 cash flow in the first year can now be added

to this figure to get to $104.97. This is now discounted for one year by dividing by 1.03 to arrive at the

present value of $101.91.

If interest rates rise to 5% the calculation would be as follows: $104 Ã· 1.05 = $99.05. Add the year 1 cash

6

flow of $4 to get to $103.05. Now divide by 1.05 to get to the present value of $98.14. The debt has fallen

in value by $1.86.

I am assuming that the underlying creditworthiness of the borrower does not change.

7

The basic principle is that governments want to encourage steady economic growth and stable low

8

inflation as opposed to what might be termed boom and bust. If economies need stimulating then

interest rates are reduced in order to stimulate new investment. If economies are in danger of over-

heating, interest rates are increased in order to reduce spending.

32 The five financial building blocks

If lenders know when they want the interest and principal repayments to

be made then a fixed rate loan can give them absolute certainty. So in our 4%

example, if a lender knows that he wants to get back $4 next year and $104

in two yearsâ€™ time and interest rates are 4%, then lending $100 at 4% fixed is

the no-risk way to achieve his objective. Suppose, though, that the lender did

not know exactly when he wanted the money back. We know that a lender

does not have to wait for the loan itself to be repaid because he can always

sell it. How could a lender always be sure he could sell his loan for its face

value and thus recoup his capital? The way to achieve this would be to lend

at a floating rate.

Borrowers see a different picture. From a borrowerâ€™s perspective it is fixed

rate borrowing that is certain whereas floating rate borrowing brings the risk

that the interest rate charge might increase. The balance between the two is

set by competitive forces. At any point in time supply and demand reach a

balance through small changes in the relationship between fixed and float-

ing interest rates. Financial markets are ideally placed to achieve this because

money is so easy to buy and sell compared with physical commodities such

as oil or copper. If one considers averages over a long period, floating interest

rates tend to be slightly lower than fixed rates. At any point in time, however,

it is perfectly possible for floating rates to be higher than fixed. This would

happen when the view of financial markets was that floating rates were at a

peak and would soon fall.

Long term or short term?

Consider now the period of a loan. It is quite easy to think of borrowers

needing to match the period of the loan to the life of the asset which they

wish to purchase. It is also reasonable to think that lenders would be happy

to consider a loan as being risk free as long as the period of the loan was no

longer than a conservative estimate of the life of the asset. If, for example,

you need a loan to buy a house you can feel quite comfortable about repaying

it over, say, 25 years. By contrast, most people would not want to borrow for

over three years to buy, say, a laptop computer because it may well be obsolete

before they had repaid the loan. One way to reduce risk on a loan is to match

the period of the loan with the life of the asset.

In an undeveloped economy, lenders and borrowers would have to seek

each other out. It would be a great challenge to find the match between the

lender who wanted to lend at, say, a fixed rate for 20 years and the borrower

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