A. I believe it is good for a firm to take a look at interest rate risk as they

Question

A. I believe it is good for a firm to take a look at interest rate risk as they go through the process of determining an optimum mix of variable versus fixed interest rates. Interest rate risk is the risk they face "that the fair values or cash flows of interest-sensitive assets or liabilities will change if interest rates increase or decrease" (Kieso, Weygandt, Warfield, 2007, P. 868). The advantage to the firm of fixed interest rates is the annual expense can be determined with a reasonable degree of accuracy in advance. However, the fixed rate can be a disadvantage if the market interest rate available to the firm decreases over an extended period compared to the fixed rate. The advantage of having a variable interest rate is the rate can vary over time. Obviously, the advantage to the firm will occur when the market interest rate declines and the firm can take advantage of the lower interest rate. The disadvantage will occur with the variable rate if the new current rate has a substantial increase that the company must now commit to. The disadvantage overall of the variable rate is it is difficult to predict in advance what the new rates will be. Management has to use its best judgment in evaluating the alternatives with respect to the type of interest rate it is interested in.

What are your thoughts on this issue?

B.

The opening moments of this article sets out to establish a well-known fact: "The economy of a country is determined in most cases by banking stability." By operations maintained by the Federal Reserve, Wall Street, and so on, we, as Americans, know this to be true. However, it is always intriguing to uncover the specifics behind such a truth as it applies in other countries, as it is the case within this journal piece as it analyzes the long-term debt paying ability, or solvency, of the European Republic of Kosovo. Furthermore, it aims to develop links between Kosovo's solvency and its relations to banks throughout the nation, and finally intends to offer recommendations to the Republic which intend to provide it with further pathways to traverse which may increase its banking stability and, henceforth, its economy.

The article describes its analysis of Kosovo and its banking system as a paper depicting means by which Kosovo's government can establish a watchful eye over its banking system by developing further systems of governance over its central and commercial banking sectors. Different theorists were apparently incorporated into this study to provide it a broad, encompassing perception of just what it might mean to restructure the Republic of Kosovo's banking system in such a way to reflect stronger solvency from financial and operative standpoints within the country. Ultimately, this dissertation between various economic theorists and professionals was conducted over a nearly two year period between September 2012 and June 2014 and maintains a thorough set of analyses of Kosovo's banking system, alongside ideas that may be able to help restructure it into a stronger economic position over time.

All in all, what this article is calling for is a respect to corporate governance within the Republic of Kosovo, which, at least if one were to only assess this entry as their only significant window into the world of Kosovo's economy, one might expect to be a wholly operational point. Better yet, this point serves itself as a vehicle to operate the larger picture, which, as it is constantly detailed within the article, a reflection on Kosovo, its solvency, and how it applies itself to its banking system and, henceforth, its economic state, at large. Kosovo is a country which just recently broke into independence from Serbia as of less than a decade ago in 2008, and when a portion of a country moves forward to develop a new system of governance all their own, there is bound to be room for improvement, which I had assessed the crux of the article to largely be about, and mostly from an economic perspective. Purely using this article as a means of peering into the state of Kosovo's economy, I would say that there is proof positive that the country can improve upon its economic standing through a further embrace of financial and operational solvency in its banking system.

What are your thoughts on this?

Explanation / Answer

A} Debt is one of the most efficient ways of raising the capital for firms and deciding the optimal mix of bonds which have fixed and variable interest rate becomes very important. This task is highly subjective with respect to each firm as it depends on the bargaining power of the firm to raise debt capital. A firm which has only “AAA” rated debt outstanding and wants to issue some more debt might not face the difficulties which a “BBB” rated debt outstanding firm. The firm which is placed in a position to borrow at a comparatively less cost of debt can hedge its interest rate risk by issuing bonds with call options embedded in it, which will help the firm recall the bonds if the market interest rate is below the issue interest rate and the bonds are valued more. If the company is not in a position to have this bargaining power then they might be forced to issue puttable bonds which then will give the power to lender/investor to put the bonds when the market rates favor the lender/investor.

Spot and Forward curves gives good amount of information on the direction in which the interest rates are heading but even these are subject to change to major economic shocks. A firm which has a healthy debt recycling history can bargain inputs from it to decide on the optimal mix of bonds which are issued at fixed interest rate or variable interest rate. Fixed interest rate instruments do not attract more investors if the general market sentiment is that of increase in interest rates in coming days and might hinder the process of raising debt capital and this might prompt the firms to issue variable interest bonds which gradually see a spike in the interest rates over a period of time. As you mentioned, yes it is very important for firms to look at interest rate risk measure before deciding on the issuance of fixed/variable rate bonds as it decides the future payments. Firms usually hedge the interest rate risk to avoid the uncertainty.

Another key important point which firms consider before deciding on the issuance of fixed/variable interest rate bonds is that the nature of its equity investor. Equity investors are those who have committed to assume the risk and the firm hedging away the risk of uncertainty in any form might not go well with them (this is one of the reasons why even the raw materials requirements too aren’t hedged by many firms) and it impacts the decision of debt issuance.

B} The stronger the banking system of a country the strongest will be its economy as it determines the flow of money throughout the economy. It becomes even more important for the country like Kosovo which is disputed zone and trying to cope up with fitting into a union. To have a strong banking system in a country it should be functioning independent of the government of that country but in cooperation. If the government has the control over the banking system it might use it to hide its own inability of fiscal decisions. Financial and operational solvency in the banking system is an absolute must for an economy to grow strong and sustain it over a span of decades and for an economy like Kosovo which is taking baby steps has the advantage of being able to set an agenda where it wants to head and build a strong base. Developing new system of governance takes years but the ability to build a banking system which will have operational and financial solvency gives a good start. Strong fiscal decisions by the Kosovo government should give its central bank a free hand to control the monetary decisions, which will result in an efficient banking system. If instead the central bank is influenced to align its policies with that of government of Kosovo, it might end up with a less efficient system and slack economy.

Kosovo has the potential to turnaround its economy by means banking system as the banking system of Kosovo is more than 65% of its total finance industry. One of the important things which Kosovo’s central bank has to regulate is non performing assets. The outstanding loan amount should be recoverable over the duration it is issued and the increase in non-performing assets will not help operational efficiency. The government of Kosovo must ensure the industrial production is encouraged and more investment is attracted in the country. Its ability to govern and more independence to the firms operating within the country will aid the economy. Putting too much pressure on banking system might not give the long term solution to Kosovo as banking system should function as support system to all other goods and services industry and not become the central point of all the industries.

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