further in Chapter 6.
1.7 CREDIT RATINGS
Credit ratings provide information that is widely used by financial market participants for the management of credit risks. A credit rating is a measure of the credit quality of a debt instrument such as a bond. However, the rating of a corporate or sovereign bond is often assumed to be an attribute of the bond issuer rather than of the bond itself. Thus, if the bonds issued by a company have a rating of AAA, the company is often referred to as having a rating of AAA.
The three major credit rating agencies are Moody’s, S&P, and Fitch. The best rating assigned by Moody's is Aaa. Bonds with this rating are considered to have almost no chance of defaulting. The next best rating is Aa. Following that come A, Baa, Ba, B, Caa, Ca, and C. The S&P ratings corresponding to Moody's Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C are AAA, AA, A, BBB, BB, B, CCC, CC, and C, respectively. To create finer rating measures Moody's divides the Aa rating category into Aa1, Aa2, and Aa3; it divides A into A1, A2 and A3; and so on. Similarly S&P divides its AA rating category into AA+, AA, and AA−; it divides its A rating category into A+, A, and A−; and so on. Moody's Aaa rating category and S&P's AAA rating are not subdivided, nor usually are the two lowest rating categories. Fitch's rating categories are similar to those of S&P.
There is usually assumed to be an equivalence between the meanings of the ratings assigned by the different agencies. For example, a BBB+ rating from S&P is considered equivalent to a Baa1 rating from Moody’s. Instruments with ratings of BBB− (Baa3) or above are considered to be investment grade. Those with ratings below BBB− (Baa3) are termed noninvestment grade or speculative grade or junk bonds. (In August 2012, S&P created a stir by downgrading the debt of the U.S. government from AAA to AA+.)
We will learn a lot more about credit ratings in later chapters of this book. For example, Chapter 6 discusses the role of ratings in the credit crisis that started in 2007. Chapters 15 and 16 provide information on how ratings are used in regulation. Chapter 19 provides statistics on the default rates of companies with different credit ratings. Chapter 21 examines the extent to which the credit ratings of companies change through time.
SUMMARY
An important general principle in finance is that there is a trade-off between risk and return. Higher expected returns can usually be achieved only by taking higher risks. In theory, shareholders should not be concerned with risks they can diversify away. The expected return they require should reflect only the amount of systematic (i.e., non-diversifiable) risk they are bearing.
Companies, although sensitive to the risk-return trade-offs of their shareholders, are concerned about total risks when they do risk management. They do not ignore the unsystematic risk that their shareholders can diversify away. One valid reason for this is the existence of bankruptcy costs, which are the costs to shareholders resulting from the bankruptcy process itself.
For financial institutions such as banks and insurance companies there is another important reason: regulation. The regulators of financial institutions are primarily concerned with minimizing the probability that the institutions they regulate will fail. The probability of failure depends on the total risks being taken, not just the risks that cannot be diversified away by shareholders. As we will see later in this book, regulators aim to ensure that financial institutions keep enough capital for the total risks they are taking.
Two general approaches to risk management are risk decomposition and risk aggregation. Risk decomposition involves managing risks one by one. Risk aggregation involves relying on the power of diversification to reduce risks. Banks use both approaches to manage market risks. Credit risks have traditionally been managed using risk aggregation, but with the advent of credit derivatives the risk decomposition approach can be used.
FURTHER READING
Markowitz, H. “Portfolio Selection.” Journal of Finance 7, no. 1 (March 1952): 77–91.
Ross, S. “The Arbitrage Theory of Capital Asset Pricing.” Journal of Economic Theory 13, no. 3 (December 1976): 341–360.
Sharpe, W. “Capital Asset Prices: A Theory of Market Equilibrium.” Journal of Finance 19, no. 3 (September 1964): 425–442.
Smith, C. W., and R. M. Stulz. “The Determinants of a Firm's Hedging Policy.” Journal of Financial and Quantitative Analysis 20 (1985): 391–406.
Stulz, R. M. Risk Management and Derivatives. Mason, OH: South-Western, 2003.
PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
1. An investment has probabilities 0.1, 0.2, 0.35, 0.25, and 0.1 of giving returns equal to 40 %, 30 %, 15 %, −5 %, and −15 %. What is the expected return and the standard deviation of returns?
2. Suppose that there are two investments with the same probability distribution of returns as in Problem 1.1. The correlation between the returns is 0.15. What is the expected return and standard deviation of return from a portfolio where money is divided equally between the investments?
3. For the two investments considered in Figure 1.2 and Table 1.2, what are the alternative risk-return combinations if the correlation is (a) 0.3, (b) 1.0, and (c) −1.0?
4. What is the difference between systematic and nonsystematic risk? Which is more important to an equity investor? Which can lead to the bankruptcy of a corporation?
5. Outline the arguments leading to the conclusion that all investors should choose the same portfolio of risky investments. What are the key assumptions?
6. The expected return on the market portfolio is 12 % and the risk-free rate is 6 %. What is the expected return on an investment with a beta of (a) 0.2, (b) 0.5, and (c) 1.4?
7. “Arbitrage pricing theory is an extension of the capital asset pricing model.” Explain this statement.
8. “The capital structure decision of a company is a trade-off between bankruptcy costs and the tax advantages of debt.” Explain this statement.
9. What is meant by risk aggregation and risk decomposition? Which requires an in-depth understanding of individual risks? Which requires a detailed knowledge of the correlations between risks?
10. A bank's operational risk includes the risk of very large losses because of employee fraud, natural disasters, litigation, etc. Do you think operational risk is best handled by risk decomposition or risk aggregation? (Operational risk will be discussed in Chapter 23.)
11. A bank's profit next year will be normally distributed with a mean of 0.6 % of assets and a standard deviation of 1.5 % of assets. The bank's equity is 4 % of assets. What is the probability that the bank will have a positive equity at the end of the year? Ignore taxes.
12. Why do you think that banks are regulated to ensure that they do not take too much risk but most other companies (for example, those in manufacturing and retailing) are not?
13. List the bankruptcy costs incurred by the company in Business Snapshot 1.1.
14. The return from the market last year was 10 % and the risk-free rate was 5 %. A hedge fund manager with a beta of 0.6 has an alpha of 4 %. What return did the hedge fund manager earn?
FURTHER QUESTIONS
15. Suppose that one investment has a mean return of
