When bankers provide loans to foreign borrowers they face
a risk of the borrower defaulting and another risk due to a change in the exchange rate
currencies.
Banks decide the rate of interest that is
charged based on the credit rating of foreign borrowers provided by credit rating
agencies. These are calculated by the rating agencies based on the assets and
liabilities of the borrowers and the anticipated cash flows. Banks have to discount the
ratings of the borrower with the credit rating of the nation in which the borrower is
based. For example, if there are two borrowers with similar credit ratings, one based in
the UK and the other in Greece, the bankers would have to take into account the fact
that Greece has a lower credit rating than the UK, and therefore charge a higher rate of
interest from the borrower based in Greece. This is one of the ways in which the default
risk can be reduced.
The exchange rate risk arises due to
fluctuations in the exchange rate of currencies which may lead to a difference in the
exchange rate when the loan is issued and when it has to be repaid. This can be dealt
with using currency derivatives, which include futures and
options.
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