RISK MANAGEMENT THOUGHT LEADERSHIP

Sign up to Newsletter

Credit Spreads in Foreign Currencies

White paper


Credit Spreads in Foreign Currencies

In the interest paid by a financial institution to secure funding there are several components, the risk free interest rates, the sovereign risk and the endogenous risk of the institution itself. If it not always easy to disentangle these components and in some cases, where markets are illiquid, the task is nearly impossible.

On the way to accomplish the task there are at least two serious obstacles: very few bonds issued on the domestic market that makes it hard to read off the ‘risky’ interest rate paid, and a poorly developed swap market, that makes it impossible to extract the risk free rate. This second point is very relevant in as much as in many operations we care for the spread between the risky rate and the risk free one.

From the CIP parity relation, as presented in schoolbooks, we know that we could resort to the foreign market to read off the missing data, and the translation factor can be read off the FX market. Unfortunately the appearance of basis spread casts some doubt on the validity of this approach.

In this paper we look at this problem and, analyzing market data, we try to assess where the CIP relation, adjusted for the spread from CCS, can provide a useful guide in establishing a reasonable level for both the risk-free and the risky rates.