investors have to underlying derivatives. The Eurodollar futures contract is
without question the most liquid and most actively traded futures contract
in the world.
Although the swap market with all of its attendant product venues is a
credit market (in the sense that it is not a triple-A Treasury market), it is a
credit market for one rather narrow segment of all credit products. While
correlations between the swap market (and its underlying link to banks and
financial institutions) and other credit sectors (industrials, quasi-govern-
mental bodies, etc.) can be quite strong at times (allowing for enticing hedge
and product substitution considerations, as will be seen in Chapter 6), those
correlations are also susceptible to breaking down, and precisely at moments
when they are most needed to be strong.
For example, stemming from its strong correlation with various non-
Treasury asset classes, prior to August 1998, many bond market investors
actively used the swaps market as a reliable and efficacious hedge vehicle.
But when credit markets began coming apart in August 1998, the swaps mar-
ket was particularly hard hit relative to others. Instead of proving itself as
a meaningful hedge as hoped, it evolved to a loss-worsening vehicle.
Chapter 6 examines how swaps products can be combined with other
instruments to create new and different securities and shows how swap
spreads sometimes are used as a synthetic alternative to equities to create a
desired exposure to equity market volatility.
An adverse or favorable piece of news of a credit nature (whether from a
credit agency or any other source) is certainly likely to have an effect on an
equityÔÇ™s price. A negative piece of news (as with a sudden cash flow prob-
lem due to an unexpected decline in sales) is likely to have a price-depress-
ing effect while a positive piece of news (as with an unexpected change in
senior management with persons perceived to be good for the business) is
likely to have a price-lifting effect.
With some equity-type products, such as preferred stock, there can be
special provisions for worst-case scenarios. For example, a preferred stockÔÇ™s
82 PRODUCTS, CASH FLOWS, AND CREDIT
prospectus might state that in the event that a preferred issue is unable to
make a scheduled dividend payment, then it will be required to resume pay-
ments, including those that are overdue, with interest added provided that
it is able to get up and running once again. This type of dividend arrange-
ment is referred to as cumulative protection.
While many investors rely on one or more of the rating agencies to pro-
vide them with useful information, out of fairness to the agencies and as a
warning to investors, it is important to note that the agencies do not have
a monopoly on credit risk data for three reasons.
1. Rating agencies are limited by the information provided to them by the
companies they are covering and by what they can gather or infer from
any sources available to them. If a company wants something withheld,
there is generally a good chance that it will be withheld. Note that this
is not to suggest that information is being held back exclusively with a
devious intention; internal strategic planning is a vital and organic part
of daily corporate existence for many companies, and the details of that
process are rightfully a private matter.
2. Rating agencies limit themselves to what they will consider and discuss
when it comes to a companyÔÇ™s outlook. The agencies cannot be all things
to all people, and generally they are quite clear about the methodolo-
gies they employ when a review is performed.
3. Rating agencies are comprised of individuals who commonly work in
teams, and typically committees (or some equivalent body) review and
pass ultimate judgment on formal outlooks that are made public. While
a committee process has its merits, as with any process, it may have its
shortcomings. For example, at times the rating agencies have been crit-
icized for not moving more quickly to alert investors to adverse situa-
tions. While no doubt this criticism is sometimes misplacedÔÇ”sometimes
things happen suddenly and dramaticallyÔÇ”there may be instances when
the critique is justified.
For these reasons, many investors (and especially large fund managers)
have their own research departments. Often these departments will subscribe
to the services of one or more of the rating agencies, although they actively
try to extend analysis beyond what the agencies are doing. In some cases
these departments greatly rely on the research provided to them by the invest-
ment banks that are responsible for bringing new equities and bonds to the
marketplace. In the case of an initial public offering (IPO), investors might
put themselves in a position of relying principally and/or exclusively on the
research of an investment bank.
As the term suggests, an IPO is the first time that a particular equity
comes to the marketplace. If the company has been around for a while as a
privately held venture, then it may be able to provide some financial and
other information that can be shared with potential investors. But if the com-
pany is relatively new, as is often the case with IPOs, then perhaps not much
hard data can be provided. In the absence of more substantive material, rep-
resentations are often made about a new companyÔÇ™s management profile or
business model and so forth. These representations often are made on road
shows, when the IPO company and its investment banker (often along with
investment banking research analysts) visit investors to discuss the antici-
pated launching of the firm. Investors will want to ask many detailed ques-
tions to be as comfortable as possible with committing to a venture that is
perhaps untested. Clearly, if investors are not completely satisfied with what
they are hearing, they ought to pass on the deal and await the next one.
For additional discourse on the important role of credit ratings and their
impact on equities, refer to ÔÇťThe Long-run Stock Returns Following Bond
Ratings ChangesÔÇŁ published in the Journal of Finance v. 56, n. 1 (February
2001), by Ilia D. Dichev at the University of Michigan Business School and
Joseph D. Piotroski at the University of Chicago. They examine the long-
run stock returns following ratings changes and find that stocks with
upgrades outperform stocks with downgrades for up to one year following
the rating announcement.
Their work also finds that the poor performance associated with down-
grades is more pronounced for smaller companies with poor ratings and that
rating changes are important predictors of future profitability. The average
company shows a significant deterioration in return on equity in the year
following the downgrade.
Finally, as we will see in Chapter 5, some investors make active use of
a companyÔÇ™s equity price data to anticipate future credit-related develop-
ments of a firm.
Generally speaking, the rating agencies (MoodyÔÇ™s, Standard & PoorÔÇ™s, etc.)
choose to assign sovereign ratings in terms of both a local currency rating
(a rating on the local government) and a foreign currency rating
84 PRODUCTS, CASH FLOWS, AND CREDIT
(a rating on capital restrictions, if any). Why do the rating agencies frame
their creditworthiness methodology around this particular financial variable
(i.e., currency)? Presumably it is because they are confident that this partic-
ular instrument is up to the all-important role assigned to it. The purpose
here is not to hype the role of currencyÔÇ”clearly it cannot possibly embody
every nuance of a countryÔÇ™s strengths and weaknessesÔÇ”but with all due
apologies to Winston Churchill, despite its shortcomings, currency may be
the best overall variable there is for the task.
For most of the developed countries of the world, a local currency rat-
ing and foreign currency rating are the same. As we move across the credit
risk spectrum from developed economies to less developed economies, splits
between the local and foreign currency ratings become more prevalent. What
exactly is meant by a local versus a foreign currency rating?
When assigning a local currency rating, the rating agency is attempting
to capture sentiment about a countryÔÇ™s ability (at the government level) to
make timely payments on its obligations that are denominated in the local
currency. Thus, this rating pertains to the ability of the U.S. government to
make timely payments on U.S. Treasury obligations (Treasury bills, notes,
and bonds) denominated in U.S. dollars. Just to highlight a historical foot-
note, not too long ago the U.S. government issued so-called Carter Bonds,
which were U.S. Treasury bonds, denominated in deutsche marks. Their pur-
pose was to allow U.S. Treasuries to be more appealing to offshore investors
and to collect much-needed foreign currency reserves at the same time.
During the Reagan administration, the issuance of yen-denominated
Treasuries was considered, but it was not done.
Of course, not only is it of relevance that a given country can make
timely payments on its obligations denominated in its own currency, but it
is important that the local currency has intrinsic value. ÔÇťIntrinsic valueÔÇŁ does
not mean that the currency is necessarily backed by something material or
tangible (as when most major currencies of the world were on the gold stan-
dard and what kept a particular currency strong was the notion that there
were bars of gold stacked up in support of it), but rather that there is the
perception (and, one hopes, the reality) of political stability, a strong eco-
nomic infrastructure, and so forth.
From one rather narrow perspective, a country always should be able
to pay its obligations denominated in its local currency: when it has unfet-
tered access to its printing presses. If having more of the local currency is as
simple as making more of it, what is the problem? Such a casual stance
toward debt management is not likely to go unnoticed, and in all likelihood
rating agencies and investors will consider the action to be cheapening a
countryÔÇ™s overall economic integrity (not to mention the potential threat to
inflation pressures). In short, while it may be theoretically (or even practi-
cally) possible for a country to print local currency on a regular basis sim-
ply to meet obligations without concomitantly working to implement more
structural policies (i.e., improving roads and schools, or promoting more self-
sustaining businesses for internal demand or external trade), as a long-run
cornerstone of economic policy, it is perhaps not the most prudent of poli-
cies. This is certainly not to say that a country should not take on debtÔÇ”
perhaps even a lot of it; it simply is to say that prudence suggests that cou-
pling debt with sound debt management is clearly the way to go. And what
is sound debt management, or, equivalently, an appropriate amount of debt
for a given country? With the blend of political, economic, regional, and
other considerations that the rating agencies claim to evaluate, on the sur-
face it would appear that no pat answer would suffice, but rather that a case-
by-case approach is useful.
Meanwhile, a foreign currency rating applies to a countryÔÇ™s ability to
pay obligations in currencies other than its own. If the local currency was
freely convertible into other currencies, then presumably securing a strong
credit rating would not be an issue. However, many countries have in place
(or have a history of putting in place) currency controls. Such restrictions
on the free flow of currency can be troubling indeed. If a particular coun-
try were fearful of a flight of capital, whereby local currency were to
quickly flee the country in search of safe havens offshore, then presumably
one way to squash such an event would be to limit or even prohibit any exit
of capital by effectively shutting down any venues of currency conversionÔÇ”
any nonÔÇ”black market venues, that is.
So can a country go into default?
First, if it does not have unfettered access to printing presses, a country
cannot monetize itself out of an economic dilemma. For example, the
European Central Bank is exactly thatÔÇ”a central bank for Europe. Thus,
no one participating member country (i.e., Germany) can unilaterally print
more euros for its own exclusive benefit. It is the same idea with the 50 states
of the United States; if New York were to issue its own state bonds and not
be able to generate sufficient revenues to pay its obligations, state authori-
ties have no ability to just print dollars. Going another layer deeper, at the
city level, the same applies. If New York City were to become at risk of
default (as it was in the 1970s), the printing press does not exist as an option.
However, if the federal government were to get involved, it becomes an
entirely different matter.
A second way a country can go into default is if it has cheapened its cur-
rency to such a point that it is essentially deemed to be worthless. Again, such
cheapening may be the result of political dynamics (e.g., a coup dÔÇ™├©tat), eco-
nomic considerations (the loss or drastic curtailment, perhaps due to natural
86 PRODUCTS, CASH FLOWS, AND CREDIT
disaster, of an essential national industry or revenue-generating resource), an
externally imposed event (a declaration of war or comparable action of hos-
tility), or perhaps some other consideration.
We now need to consider a very real implication of the fact that busi-
nesses are, of course, domiciled within countries. The default of a sovereign
nation is likely to have an adverse effect on any company located within that