Role Of Depreciation And Investment Tax Credits Essay Sample
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Introduction of TOPIC
Depreciation and investment tax credits play a critical role in stimulating investment because they reduce cost of operations. This is an issue of cost minimization which is a critical success factor in the current business environment which is characterized by a high level of competitiveness. In this respect, the management of an organization has three strategies at their disposal: differentiation, cost minimization and quick response. The policies of depreciation and investment tax credits directly address the issue of cost minimization and therefore stimulate investment. Both these policies are adopted by the governments in developing and industrial nations in order to attract foreign direct investment which stimulated economic growth.
Businesses invest in plant and equipment in order to enhance their competitive advantage. This takes place in the form of private investment. The level of private investment contributes to government revenue which is one of the key macroeconomic indicators. Therefore it is critical for the government to implement policies which are likely to stimulate investment. In this respect, accelerated depreciation policies and investment tax credits are the most recognized policy instruments. However these instruments may be misused by the governments in developing countries where the infrastructure is not adequate. In order to compensate for these deficiencies, governments in developing countries experiment with the policies of depreciation and investment tax credits in order to attract foreign investors. These strategies are effective in attracting multinational companies which generate additional revenue for the government in the host country as well as generating additional employment opportunities. For this reason, foreign direct investment is one of the most important components of stimulating economic growth. This component is directly related to the policy instruments of depreciation and investment tax credits because both these instruments seek to create incentives for investors to purchase more and thereby generate revenue.
Investment tax credits are tax savings that businesses can generate by investing in additional plant and investment. Depreciation is the process of reducing worth of plant and equipment as they are used. Depreciation is entered in the income statements and is deducted from gross profits. Therefore, depreciation reduces the level of net profits and the level of tax expenses. In this respect, businesses have four different depreciation methodologies: straight line depreciation, accelerated depreciation, activity depreciation and sum-of-the-years digits depreciation. The advantage with the depreciation methodologies is that the generally accepted accounting principles do allow the management in an organization to apply different methodologies according to the situation deemed best. Therefore, this flexibility acts as an investment stimulant in the form of reducing the level of taxable income. This is the concept of tax shield. Tax shields are best capitalized upon under the framework of the accelerated method of depreciation. According to this methodology, businesses can depreciate the plant and equipment faster in the initial periods. This increases net profits.
Combining the instruments of investment tax credits and depreciation maximizes the effect of investment stimulation by not only creating greater growth opportunities for the businesses but by also actually reducing the cost of capitalizing on these growth opportunities. Businesses in the Western economies for example are facing the threat of maturing demand in a wide variety of product categories. Therefore they do need to expand to other countries which are only beginning to generate economic growth and therefore present strong market demand. However in most of these developing countries, the level of infrastructure in terms of transport, roads and highways is highly inadequate and makes it difficult to manage the supply chain. In this case, investment tax credits are the only reason for multinational corporations to expand to these regions. In expanding to these regions, it is critical for the businesses to offer low prices. However this is not possible when one takes into account the inefficient infrastructure which increases the cost of operations.
With increasing cost of operations, businesses have to charge high prices. This impairs their competitive advantage in markets which are economically still weak and therefore are characterized by limited purchasing power. This limited purchasing power is the result of insufficient employment opportunities as a result of which the government has to support most of the population. For this reason, the governments in developing countries are eager to attract foreign investment. This objective of attracting foreign investments is met through the implementation of investment tax credits because it enables multinational companies to maintain competitive advantage in terms of low costs despite the lack of infrastructural facilities. However the governments in advanced economies have also found it to be an effective instrument to adopt investment tax credits in stimulating investment. This is because, as mentioned before, businesses face the threat of maturing demand in advanced economies. Therefore they have to maintain a continuous improvement process in order to differentiate their products and services.
In highly competitive industries, businesses have to engage in continuous improvement programs in order to maintain their competitive advantage. However the incentive to create new sources of competitive advantage depends on the level of demand which in maturing economies is weak. Therefore it depends upon businesses to research the market in order to create new products and services which would inject new energy into demand. This is where the instruments of investment tax credits and depreciation become critical. In the event that there is not enough demand in the market, the government can initiate investment tax credits and tax shields in order to motivate businesses to invest in new plant and equipment. This will motivate businesses to create new products and services which have good profit potential. In other words, these instruments enable business to move to a new level of profit maximization. For this reason, depreciation and investment tax credits play the role of generating additional earnings for the businesses.
Depreciation and investment tax credits act as powerful investment stimulants because they reduce the costs of operations. By depreciating the equipment in the initial phases, businesses can reduce the level of taxable income while businesses can earn investment tax credits by investing in new business opportunities. Therefore these two instruments play the role of facilitating tax policy objectives.
Effect of tax policies
Tax policies have the effect of raising the level of investment because they determine the cost of capital for businesses. In the case of lower taxation, businesses are motivated to invest more because they can borrow capital at a reduced rate. This is because they are enjoying higher net profits. This means that there is more capital available for reinvestment. However reinvestment will not take place unless there is demand for their products and services in the market. Tax policies have the effect of raising market demand as well because it stimulates consumer spending. As a result, businesses have the motive to raise supply and in order to meet the objectives of enhanced level of supply they are determined to invest more. The cycle of enhanced demand and the resultant level of enhanced supply is the effect of tax policies.
Tax policies are formulated as part of the fiscal policy. The government makes use of the fiscal policy to control the level of economic activity. The economic activity is essentially the level of private investment taking place at any one point in time. Therefore, tax policies and the level of private investment are directly related. This is because businesses can only expand through investment in more plant and equipment. With business expansion, government revenue goes up. Therefore, governments are motivated to reduce the level of taxes so that businesses will have more income with which to finance expansion strategies. These expansion strategies are directed towards maximization of profits. Therefore, tax policies present an instrument of controlling the level of business activity. This control is maintained through the link between investment and tax policies.
Tax policies are formulated by the government to stimulate the level of business investment. This occurs when the level of taxation is reduced. The opposite occurs when the level of taxation is enhanced. Thus there is a negative relationship between the level of taxation and the level of private investment. The level of taxation is dependent on whether the government has a fiscal deficit or not. In the case of a fiscal deficit, the government pursues expansionary fiscal policies. These policies might include issuing bonds. However, issuing bonds also means that the government has to make periodic interest payments. Therefore, if the interest payments are too high or the repayment amount is too large, then the effect might be to actually aggravate the deficit. In such cases, the government might pursue the other instrument of enhanced taxation. This means businesses are forced to pay more from their net profits. In such cases businesses can follow the strategy of varying their depreciation methodologies in order to vary the level of taxable income. However the effect is negligible in the face of tax policies which are targeting higher net taxes.
According to the above, the level of private investment is directly related to whether the government is pursuing expansionary fiscal policies or not. In the case of expansionary policies, businesses are motivated to enhance the level of investment because the same level of taxable income is taxed to a lower percentage. However, as mentioned before, lower taxes are also conducive to enhanced consumer spending because personal income is taxed less. Tax policies therefore affect investment by affecting the level of demand in the market. This is particularly so where the market is characterized by a high level of competitive intensity. In this situation, it is only through a continuous process of investment that businesses can maintain their competitive advantage. The incentive to invest is inversely related to the level of taxation because it determines the portion of capital income that is to be reinvested into the business. When capital income is taxed less, there is a greater incentive to invest. This is because the additional income generated from the new investment is taxed at a lower percentage.
Tax policies usually focus on four areas: accelerated capital consumption allowances, investment tax credits, full expensing of R&D investments and corporate tax reductions. Accelerated capital consumption allowances lead to a greater level of investment because the allowances enable businesses to depreciate their plant and equipment at a faster rate in the initial periods and the faster depreciation rates reduce the level of taxable income. In this manner, the allowances act as investment stimulants. This is primarily in the form of modernization, replacement or expansion. Businesses are motivated to modernize their existing plant and equipment because by doing so they can actually reduce the level of taxable income. This is so because by accelerating the depreciation rate of the newly purchased plant and equipment, they can reduce the level of taxable income. Because the plant and equipment are depreciated faster, this also means that businesses have to replace their physical assets sooner. Therefore, accelerated capital consumption allowances act as investment stimulants in both respects.
In the case where capital consumption allowances are combined with investment tax credits, there is a considerable level of investment stimulation in the form of expansion. This is because businesses can actually reduce the level of tax expenses by investing in more physical assets and then adopting the strategy of accelerated capital consumption. The investment stimulation is strengthened by the rising level of market demand as a result. The level of demand can rise as a result of the tax policies mentioned here because corporate income being taxed less leads to rising earnings per share. As a result, share investors have more disposable income and this acts a stimulant for greater consumer spending. Greater consumer spending leads to a greater demand for products and services and since businesses can actually reduce the level of taxable income by investing in expansion to meet this new source of demand, the result is strong investment stimulation in the corporate sector. The same can be said for full expensing of R&D expenditures. This allows businesses to invest more in research and development in order to differentiate their products and service and therefore the result is once again investment stimulation.
The effect of tax policies on investment is inversely proportional. As a result governments need to reduce the level of taxation in order to generate greater investment. In the process, there is loss of government revenue. However this loss is compensated for by the level of greater investment in physical infrastructure. This greater investment takes place in the form of balancing, modernizing, replacing or expansion of current equipment.
Theories of exchange rate forecasting
The liberalization of the international financial market has enabled international investors to invest in cross-border transactions. This makes the issue of exchange rate forecasting a critical concern. The process of wealth management is directly dependent upon the future dynamics of exchange rate movements. Therefore investment companies must develop models which can effectively predict the future movements of exchange rates. In this respect, these models will have to link past and present trends in macroeconomic and microeconomic indicators to future movements in exchange rates. However in some of the models that are currently available, macroeconomic and microeconomic theories are not taken into consideration. This is the case in the random walk hypothesis and in technical analysis. However two other models for exchange rate forecasting include linking macroeconomic and microeconomic phenomena to future exchange rate movements. In these four models, the focus is on predicting future exchange rate movements on the basis of available past and present information. However the quality of the forecasting is dependent on whether the information available is quarterly or monthly.
The first model for forecasting exchange rate movements deals with random walk forecasts. According to this model, any future exchange rate movements are likely to be reflected in the present trends of exchange rate movements. Therefore, the analyst picks the current exchange rate as the value to be reflected in the future. This model has been found to be effective because even in other models where efforts were made to contextualize exchange rate movements in order to enhance their predictive value, the actual results were found to be random. Therefore, according to the random walk model, the present value is the relevant value for the future. The effectiveness of this model also lies in the fact that there are so many external variables, both macroeconomic and microeconomic, that have a bearing upon exchange rate movements that the full complexity of the interactions is not captured in the current attempted models. Therefore it is impossible to base any predictions on current or past trends of exchange rate movements. In implementing this model, the exchange rate analyst treats the future movements in the form of maintaining a stable distribution which makes different values independent of each other.
In an effort to theorize on some of the randomness of future exchange rate movements, the second model draws on specific macroeconomic phenomena to account for the fluctuations in the interactions between two currencies. In this respect, the linking of monetary policy to exchange rate movements has been given particular attention. In implementing the monetary policy, the government in a particular country increases or decreases the interest rate in order to stimulate investment. For example, when interest rates are reduced, businesses have the motive to expand because the cost of capital goes dow
n. As a result, they can finance expansions in terms of greater scale of operations at a lower cost.
The exchange rate movements between two countries are considered to be in equilibrium when the purchasing power in both countries is the same. This is so because if the price of one product were lower in one country, then the consumers in the other country would buy the lower-priced product. The high level of demand would increase the price of the product and therefore purchasing power parity is restored. It is this link to purchasing power parity which the second model utilizes in forecasting exchange rate movements. The purchasing power parity is considered to be an effective indicator of future exchange rate movements because of its link to inflation which is in turn related to monetary policy adopted in a particular economy. In the event that the government raises the interest rate, then the cost of money becomes higher. As a result, foreign investors invest their assets in this currency which as a result of higher interest rates generates a greater level of return. As a result of the greater level of demand for this currency, the exchange rate goes up. This analytical framework is used to predict exchange rate movements.
Despite the link between exchange rate movements and macroeconomic phenomena, the analytical framework is not robust enough as a predictor of future exchange rate movements. This is because the general macroeconomic environment is in a constant state of change in terms what factors are important in terms affecting equilibrium relations. Some elements such as gross flows of financial capital may have played a more important role in the past in affecting equilibrium relations. Therefore maintaining the same level of association between gross flows of financial capital and future exchange rate movements would be erroneous. Another limitation of this approach is that macroeconomic data are available on a quarterly or monthly basis. However exchange rate forecasting has to take place on a daily and weekly basis. Therefore there is a conflict in periodicity. The monthly or quarterly macroeconomic may also not be relevant because of their changing contributions to the changing macroeconomic environment.
The third model for forecasting exchange rates deals with microeconomic phenomena. In this case, investors are more concerned with how individual asset prices will react to the availability of specific information. This information is not publicly available. It is reflected in the level of trading that takes place. In other words, the level of transaction flows determines future exchange rate movements.
The fourth model for forecasting exchange rates is technical analysis. According to this theory, future patterns of exchange rate fluctuations can be arrived at by extrapolating past patterns. In order for this theory to work, the past data available must exhibit a high level of fluctuations. These fluctuations can be the result of microeconomic and macroeconomic variables discussed earlier.
Linking macroeconomic and microeconomic phenomena to exchange rates has been found to be less effective than random walk or technical analysis. However macroeconomic and microeconomic contextualizing of exchange rate movements has sound theoretical reasoning behind it. Therefore, in the proper conditional form related to certain environmental characteristics, these two models can be more effective in predicting future exchange rate movements.
Managing interest rate and exchange rate risks
Exchange rate risk arises from possible variations between two currencies. Therefore it is important for companies engaged in international businesses to be able to predict future movements of exchange rates. Interest rate risk arises because of changes in the value of an investment as a result of changes in the interest rates. In order to minimize these two categories of risk, Company A could follow the strategies of diversification. This would address the issue of one investment gaining in value as a result of interest rate changes as another investment declines in value. Hedging is also another effective strategy in this respect. Thus both risks are addressable.
Hedging against foreign exchange risks can be done through exploring different financial instruments such as forwards, options, futures and swaps. These instruments also enable hedging against interest rate risks. This is because these instruments enable financial institutions to take advance position in terms of exchange rate and interest rate risks. By purchasing these instruments, Company A can minimize the level of risk exposure. Purchasing of options gives Company A the right to exercise the option whenever it deems to be the best. Swaps are also effective in minimizing exposure because by using this instrument, Company A has the opportunity to exchange fixed interest rates for floating interest rates. However, Company A must have the management committee in place in order to supervise the risk management model that is used to evaluate the risk of these derivatives. While derivatives can minimize the level of risk exposure in both respects of exchange rate movements and interest rate movements, they can also increase the level of risk because the instruments may be tied to assets that exhibit high volatility in interest rates and exchange rates. Therefore, the management of Company A must build an effective mechanism for monitoring and measuring risk.
In monitoring and measuring risk in both categories, the critical thing to do is to conduct a gap analysis between durations of assets and liabilities. In cases where assets have longer durations than liabilities, the company’s exposure to risk is heightened. In this case, the management of Company A must reduce the durations of the assets so that mismatches between future cash flows are minimized to zero. This can be done through trading in the commodity futures market. According to this trading framework, the counterparties agree to conduct a specific transaction at a pre-agreed rate at a future point in time. As a buyer of these derivatives, Company A limits the down-side risk of earnings exposure because it has the right to exercise the option at any time of its choosing in the future. This is related to the strategy of diversification mentioned before. By taking long and short positions in derivatives in different product categories, Company A can minimize the level of exposure to exchange rate and interest rate risks. This is because changes in interest rates and exchange rates will tend to vary in terms of their effects on different industries. Therefore, asset holdings spread over different industries minimize the risk that Company A will lose any money as a result of future adverse movements in exchange rates and interest rates.
The strategy of trading with futures contracts as described above is known as hedging with derivatives. This strategy has four advantages: 1) it limits the downside risk of future earnings 2) it maximizes the upside potential of future earnings 3) it minimizes income or capital volatility, and 4) it increases yield. These advantages are relevant in hedging against both exchange rate movements and interest rate movements because the nature of the risk potential in both categories is similar. Both rates fluctuate as a result of certain changes in microeconomic and macroeconomic phenomena. For example, a rising level of inflation will affect the purchasing power parity between two countries and affect the exchange rate accordingly. However the rising level of inflation will also affect interest rates as the central bank attempts to reduce the level of money supply in the economy through raising interest rates. With higher interest rates, the cost of capital will go up and as a result, business activity will slow. In this respect, with international asset holdings, Company A will face similar risks in terms of potentially higher downside risk to future earnings. This happens because a higher interest rates means that the value of its liabilities will cost more than before while the higher exchange rate reduces the value of its internal holdings. Therefore both these risks are addressable through the single strategy of futures trading. In the event that Company A processes all its liabilities through asset holdings in options and futures, any fluctuations in exchange rates and interest rates will be irrelevant.
It may not be enough for Company A to define its assets holdings and liabilities in terms of derivatives because as mentioned before, there is also a risk that these instruments might actually not lead to stable earnings because of the risks that the issuer of these instruments assumes. For example, Company A might implement the strategy of an interest rate swap with a financial institution which has a large amount of loans with interest rate caps and floors. In the case of an interest rate cap, it is Company A which moves in the money when market interest rates move up because Company A as the borrower can afford to pay a lower interest rate than the market interest rate. In the event that the issuer has a large amount of these asset holdings, it might ultimately be unable to process its contractual obligations when options are called by Company A.
In order to minimize exposure to the risk described above, the management of Company A must collect information in terms of contractual terms such as principal payments, interest reset dates and maturities. Such information will enable the management of the company to build adequate risk management models which are effective tools in minimizing risk exposure. The risk measurement process is a critical success factor in this case. The importance of this process might be ignored by the management in the confidence that asset holdings in futures contracts are adequate hedges against adverse interest rates and exchange rates. However too much trading in derivatives can have the opposite effect as the commodities they are based on might be exposed to unexpected risks the possibility of which was ignored by the issuer.
Hedging against interest rate and exchange rate risks follows a similar strategy because minimizing risk exposure in both cases involves taking a specific position in respect of future rate variations. Therefore hedging with derivatives is the best protection against both interest rate risks and exchange rate risks. Company A can address both categories of risks by diversifying its holdings across futures, options, swaps and forwards.
Attributes of Black-Scholes model
The Black-Scholes option pricing model is effective in calculating the price of call options because it takes into account the opportunity cost of buying a call option. In order to calculate this opportunity cost, the equation is divided into two parts. The first part deals with the benefit of buying a stock with the benefit being calculated as the current share price multiplied by the change in call premium which changes as a result of any change in the share price. The second part of the equation deals with the price that the issuer has to pay on the expiration date of the option. The price of the option is derived from the difference between this exercise price and the earlier benefit of owning a stock. Thus the effectiveness of the option pricing model lies in the calculation of the benefits foregone as a result of issuing a call option instead of owning stock. Both strategies can be used to finance the operations of a business. However, issuance of call options exposes the company to a greater level of risk. The Black Scholes model mitigates this risk by calculating the price.
The Black Scholes model is based on several assumptions. One assumption is that the option can be exercised only on the date of expiration. This is the case in the European markets. However, in the US, there is greater flexibility in terms of allowing the buyer to call in the option at a time of his own choosing. As a result, issuers in the US are exposed to greater risk. Therefore the additional flexibility of US call options is not taken into consideration in the model. However this is not a major concern because call options are rarely exercised except in the time period very near the end of their life. This is so because with call options exercised sooner, the buyers collects the intrinsic value of the instrument and is not exercising on the time value of the instrument which tends to go up as the instrument nears the end of its life. Therefore, buyers are more likely to exercise their options very near or on the expiration date in order to maximize their gains. This minimizes any limiting impact of the assumption about exercising on the date of expiration.
In the Black Scholes model, markets are also assumed to be efficient. In an efficient market, the investors are unable to predict future stock prices from past patterns. Therefore the model is most effective in markets where share prices follow a random walk. This is an important attribute of the model because as mentioned before, one of the two components of the Black Scholes model is concerned with calculating the benefit of owning stock instead of issuing a call option. This calculation draws upon the assumption that all future stock prices have the same probability of occurring. The assumption leads to the development of a uniform distribution model which models future share prices with known probabilities. In this respect, the bell curve model may be used. However the effectiveness of this model depends on share prices following random walk according to which each share price is arrived at independent of any occurrence in the past. This leads to the assumption that share prices have the same distribution regardless of the point of time taken into consideration in option pricing.
Another assumption of the Black Scholes model is that the stock that is taken into consideration does not pay dividends. This assumption might be detrimental to the effectiveness of the model considering the fact that most corporations pay dividends to attract share investors. In this respect, the role that share dividends play in determining the capital structure of the corporation is particularly relevant as higher dividends lead to lower call premiums. Therefore not taking share dividends into consideration might appear to be a limitation of the model. However the model does deduct the discounted value of future dividends in order to arrive at present share prices. In that respect, the model is adjustable to account for future dividends. The last assumption is that interest rates are assumed to be known and are assumed to remain constant. In this respect, the model uses the risk free rate of return. Although the risk-free rate is merely a theoretical construct, US Government Treasury Bills are considered to represent the risk-free rate of return. These bills are functional with 30 days left till maturity.
Observations in the real world have been known to differ from Black-Scholes derivations because of the simplifying assumptions made. The most common problem that arises from reconciling the results of the model to those of the real world is that in the Black-Scholes model, the implied volatility is held to be constant. But in the real world, the volatility fluctuates depending on the strike price. However the advantage of using the Black-Scholes model is that the equation can be solved for volatility with given prices, durations and strike prices. The effectiveness of the model is most in question during extreme price changes.
Although these extreme changes are unlikely, they do occur and in these cases, the model is adjustable by solving the equation with past observations. The derivations from extrapolating past observations have been found to be in agreement with actual observations. Because of this adjustability, the model is used as the basis for more refined models. Therefore the usefulness of the model is not in generating accurate results, but in generating approximations which can be adjusted to develop asset holdings in correct proportions. The model also solves for implied volatility. Therefore, options can be more effectively compared on the basis of this volatility rather than on the basis of dollars per unit which can vary across strike prices. In this respect, limited availability of information on volatility and risk-free rate of return is not a major limitation because the model still allows investors to compare different options in terms of their implied volatility by solving for such.
The Black-Scholes option pricing model is used for calculating the market value of a call option. The focus of the model is on determining the benefit to be gained by paying an exercise price that is lower than the price to be paid for acquiring stock. Although there are several simplifying assumptions in the model, it provides approximations based on which hedging strategies can be formulated.
Managing risk through derivatives
Investment companies can use credit derivatives in order to reduce their exposure to risk. The effectiveness of this strategy depends on the asset size of the companies. This is because the size of asset holdings determines the level of exposure to credit risk and depending on the magnitude of this exposure the investment banks can make use of credit derivatives examples of which include credit default swaps, total rate of return swaps, synthetic collateralized loans, debt, and commercial paper obligations.
The bulk of asset holdings in an investment company consist of commercial and industrial loans. In order to reduce the risk of non-payment, the investment company can use the instrument of a credit default swap in order to hedge against the risk. It is more profitable for the investment company to lend to a commercial or industrial institution than to an individual. However the risk is also higher in terms of the commercial or industrial venture not getting off the ground. In this case there is a substantial likelihood of default, bankruptcy or credit downgrade. In order to protect against loss in such likelihoods, the investment company buys credit protection in the form of a credit default swap which means that the investment company negotiates with a third party to sell the loan in return for an amount determined according to the different models for options pricing. The third party that buys the credit default swap assumes the risk in terms of accepting a floating interest rate on the loan which exposes this buyer to an interest rate risk. However the third party might be willing to take this risk because in the case of credit default, this company stands to gain more in terms of interest income generated than the default on the principal payment.
For an investment company, the use of derivatives can be an effective deterrent against bad loans because it allows the company to develop an additional asset class in which the commercial or industrial loan serves as the underlying product. According to traditional financial management, the loan would be regarded as an asset on the balance sheet of the company with the associated risk level assumed. However in the modern business environment which is characterized by a high level of volatility, maintaining the loan in the asset side of the balance sheet is no longer a guarantee that the investment company has healthy asset holdings. Because of the intense level of competitiveness in the current business environment, the probability of credit defaults are high. Therefore it is a critical success factor for the management of the investment company to develop hedging strategies that eliminate or minimize this risk. This can be done in the form of a credit default swap.
Strategies related to credit default swap or synthetic collateralized loans work because they enable companies with different asset profiles to develop positions that are secure against future interest rate movements. These movements are the source of the risk. The credit default swap is one of the effective strategies in this respect because it enables the investment company to exchange an asset that has a floating interest rate, such as the commercial or industrial loan, for another asset which has a fixed interest rate. Another strategy is the use of synthetic securitized loans. In this case, the investment company does not have to sell the loan on its balance sheet. Instead it securitizes the loan with another financial instrument such as the Government Treasury Bill which has a risk free rate of return because of the payback guarantee that the government provides. The use of these derivatives provides advantages for all parties concerned. For the investment bank, it means relaxation of lending controls because there is less risk of credit default as the risk is passed on to other companies in the form of derivatives. Therefore the use of derivatives has led to the development of an efficient financial management system which reduces credit risk for an investment company.
The total rate of return swap is another example of a derivative used to manage the risks of an investment company. In this case, the investment company can be either a total return payer or a total return receiver. In the case of a total return payer, the investment bank uses the interest receipts of its loan to pay the receiver of total return. In return for these interest receipts, the bank receives ongoing payments from the receiver and this eliminates the risk of credit default. However the same investment bank can also be a receiver of total return by buying such an asset which is referenced to a loan in the balance sheet of another financial institution. In this respect, the investment company as the receiver pays or receives the difference at the end of the life of the derivative. This difference is between the final value and the original value and in the event that the final value of the reference asset is higher than the original, the investment company as the receiver gains the difference.
Derivatives comprise a wide variety of financial instruments. So far the discussion has focused on credit derivatives. There are also other derivatives such as options, futures and forwards. However these categories of financial instruments are also included in credit derivatives such as in the case of synthetic collateralized loans or total rate of return swaps. In these cases, the investment company is taking long or short positions based on forwards, options and futures. In securitizing loans in the case of synthetic collateralized loans, the company is investing in options in order to hedge against risk. The same can be said for total rate of return swap as in this case, the investor is taking a position as to what the final value of the reference asset is going to be.
Derivatives are used by an investment company to hedge against risks of credit default and interest rate variations. Research studies have shown that in the case of higher percentage of foreign loans and lower capital ratios, the investment company is more likely to buy credit protection in the form of credit derivatives. Credit derivatives address these risks through securitization.
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