An Overview of Risks in Banking and Investments

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An Overview of Risks in Banking and Investments

Background

Credit ratings serve as vital tools for the investor, especially when they need a precise analysis of the organizations position at a glance. Studies by Lizarazo (2017) have shown that credit ratings influence the investors decisions on whether they will invest in a particular organization or not. Therefore, Fitch company provides a reliable credit rating, enabling the company to showcase their abilities to meet various financial requirements such as dividends, interests, and other financial obligations.

Credit Rating Comparison as Assigned by Fitch

According to the Fitch credit ratings, it was revealed that both Rio Tinto and BHP hold an A rating and are both in a stable financial situation. However, this rating does not surprise me as both companies are among the top 3 companies within the same industry. Nevertheless, the companies share many similarities and differences, which are evident upon analyzing the companys ratings (Berardi, 2018). Additionally, according to the Fitch Affirms BHP at A and Outlook stable (2019), it has been indicated that both companies have a well-established financial profile and a clear outlook with an FFO net leverage of 0.3x and 0.4x for Rio Toronto and BHP companies respectively (Carson et al, 2018). According to Fitch, both Rio Tinto and BHP can handle economic downtown and weaker demands for their services, although for different reasons.

Rio Tinto is well-positioned as they have a well-established financial position, with a substantial percentage of their earnings coming from iron ore (BHP, 2020). On the other hand, BHP is well-positioned as they have a well-established conservative position economically and an excellent business profile. With the current weak product consumption rate at BHP, studies have shown a high chance for a decrease in the global GDP by over 3.9% (BHP, 2020). Such a decrease in the global GDP is associated with driving most commodity prices such as coal, gold, and Iron ore down (Haque & Lilford, 2015). With a majority of the earnings at Rio Tinto being derived from Iron ore, there is an expected lesser impact on the overall performance as the sale of iron ore in the company accounts for nearly 65% of the total company total EBITDA (Fitch Affirms Rio Tinto at A; Stable Outlook, 2020). This has been evidenced from their 2019 financial reports whereby it has been illustrated that iron core plays a vital role in its total EBITDA.

However, liquidity for both companies seems to be firm, with BHP reporting nearly USD 14.3 liquid assets with almost 200 million in their restricted funds. On the other hand, Rio Tinto also realized USD 8.8 billion in cash and other equivalent assets (Al Mamum, 2019). From these figures, it can be well concluded that BHP company is much liquid that Rio Tinto as it meets a higher number of their short-term obligations from our present outlook is a positive (Al Mamun, 2019). However, one field in which BHP lacks a competitive advantage over Rio Tinto is the diversity of the product and services ranges. Rio Tinto is heavily on Iron ore in this area, while BHP has diversified its products to gas, aluminum, copper, and iron ore (Billiton, 2019). Nevertheless, it is worth noting that Rio Tinto has not been affected negatively by the dramatic decrease in the profitability of the iron ore in the current market as they have the diversity of a well-defined product compared to BHP (Haque & Lilford, 2015). Although, the variety of the commodities in the company may play a vital role towards the future ratings of the company, thus equipping it with a competitive advantage.

From the above analysis, it is evident that both BHP and Rio Tinto share various similarities in terms of position in the industry and financial outlook, which have proven to exist in a stable condition. In addition, both companies have a well-established solid ground upon which they can endure the global effects of the current Corona-Virus pandemic, which is why both have an A Fitch rating (Al Mamun, 2019). Furthermore, their positions in the industry play a vital role in advocating the stable outlook associated with both companies, as depicted by the ability of each of the companies to counter the current pandemic and their present profit margins.

Credit Risk Premium Calculation

Market risk premium refers to the difference between the market return and the individual investment returns. The market risk premium is calculated using the formula that has been stated below:

Market Risk Premium=r_a r_f

Where;

r_a=asset ( investment return

r_f=risk free return

From a deep analysis of the data that has been provided, we can see that the investment returns for Rio Tinto and BHP are 2.36% and 2.39%, respectively. In addition, there is a 20-year risk-free proxy for the US treasury, which is about 1.21% as of September 11^th.

Therefore, with the utilization of the above formula and other information that has been provided above, the market risk premiums for Rio Tinto and BHP are 1.05% and 1.08%, respectively.

Bid/Offer, on the other hand, represents the difference between the bid price and the Offer price of any particular investment that a company decides to engage in.

The formula that is used in the calculation of the bid /offer is stated below:

Bid /Offer spread= Offer PriceBid price

Offer price

Where;

Offer price=the price the bond ( stock is being sold at

Bid price=the price at which bidding is occurring on a bond ( stock

Using the data provided in the question, we can calculate the bid/offer spread for both stocks that have been provided. For instance, we are given the asking price of $130 and $129 for Rio Tinto and BHP, respectively. The bid prices for the companies are also provided as $127.50 and &127 for Rio Tinto and BHP, respectively.

Therefore, the Bid/Offer spread for Rio Tinto is 1,92% and for BHP is 1.55%.

Beta Calculation for BHP Billiton, Rio Tinto, and Fortescue Metals

Summary of the Calculation

The steps that were undertaken in the calculation of the beta values for each of the said stock is listed below:

The historical data related to Rio Tinto BHP and ASX200 was downloaded from yahoo finance for all the daily prices between 30^th June 2018 to 30^th June 2020 (Yahoo Finance, 2020).
The downloaded data was then checked and cleaned for any possible errors that could be evident or days without a price.
Then, the percentage returns were calculated for all the 3 data sets by using the formula: Percentage returns= (P0/P1)-1
To calculate the requested beta values for each stock, the covariance between the ASX200 and the stocks was calculated and then divided by the variance of the ASX200.

Stock with Higher Beta and its Implication

From the method used above, the beta values for Rio Tinto and BHP were 0.762 and 1.004, respectively. Usually, the beta value represents how close the individual stock can be mapped to the movement of the index. According to Kenton (2020), it may also refer to the measure of a stocks volatility compared to the index (Kenton, 2020). A beta of value above one represents the stock being more volatile than the market index. On the other hand, a beta value of 1 indicates that the volatility movements and the individual stock are the same and move with the market (Bauer et al., 2018). Lastly, a beta value below 1 indicates that the market index is higher than the stock, and therefore, the stock has fewer movements (Gitman et al., 2015). From the calculations made, we can easily determine that BHP often follows the movements in the ASX200 and, therefore, can be said to have the same volatility as its beta value is 1.004. However, Rio Tinto is less volatile than the market by nearly 25%, as the value of its beta is 0.762 (Kenton, 2020).

Risks Associated with Each of the Companies

Rio Tinto is regarded as a multi-billion dollar, multinational and metal corporation company that has set up its business globally. However, the company is associated with various risks with its bonds and shares for its investors (Capital IQ, 2020). For instance, Rio Tintos bonds are associated with Credit and Call risks, while their shares are open to operational and commodity risks.

Call risk is associated with the premature call back of bonds by a company and may result from many distinct reasons. According to Chen (2019), call risks are relevant for Rio Tintos International investors as Australia is associated with high-interest rates. Therefore, the organization can cancel its issued bonds and later issue them at a much lower interest rate. As a result, the issuer may need to reinvest their principle with the lower rate that has been created (Billiton, 2017). Despite being beneficial to Rio Tinto, this strategy has had many negative impacts on their loyal investors. In addition, the current Australian recession has been thought to affect Rio Tinto (Productivity Commission, 2020). In a recession, many companies within Australia have faced downtown performance, thus leading to lower returns for the Australian economy and global investors (Petroff, 2019). The downtown for Rio Tinto would suggest a problematic financial situation, thus making it difficult for them to generate profits and revenues, thus leading to liquidity risks.

On the other hand, commodity risks can threaten the share price of Rio Tinto with a rough value of nearly 60% of the EBITDA in the form of iron ore (Lizarazo, 2016). Therefore, Rio Tinto is set to realize considerable losses in case the price of the iron ore weakens (Cincotta, 2019). Such a loss will significantly impact global investors as their dividends and stock returns depend much on the corporations performance. Another scope that Rio Tintos share is susceptible to risks is the impact of operational risk and its effect on the organizational output and performance (Tinto, 2015). Operational risks often result when a corporation fails to fully maintain its employees and operations (Lizarazo, 2016. According to the MSCI ESG rating for Rio Tinto, the corporation has a dwindling rating, especially in its labor-management (ESG Ratings, 2020). This may result in poor annual performance and lower expected output, resulting in lower returns for the investors.

BHP is one of the largest resource and mining corporations in the globe. Like Rio Tinto, BHP does not have any potential risks for global investors (S&P Capital IQ, 2020). However, international investors need to have a deep understanding of the possible risks that may result when they choose to invest in the companys bonds and shares (BHP, 2020). With a focus on bonds, there is a need for BHP to be aware of both interest and currency rate risks. For BHP company, investors should consider issues related to market risks and those associated with corporate social responsibility and the general environmental effect.

Being an Australian-based corporation, BHP is faced with challenges related to the ever-changing currency rates. The Australian economy is associated with lower exchange rates despite holding a solid global position (Pais & Stork, 2018). The low exchange rates may negatively affect the value of an investors portfolio and assets. In addition, investors in Australia investing in BHP may face a risk associated with low-interest rates in Australia (MSCI, 2020). Currently, Australias interest rates are meager, and in case of a rise in their value, investors investments will decline considerably.

Being a globally traded and ASX company, BHP investors may decide to look into the companys shares before investing. Some of the critical risks that may be realized include environmental and market risks (Lizarazo, 2016). Market risks have been evident in the recent past due to the lack of an effective overall performance, especially during the COVID 19 times (Baur & Trench, 2020). Therefore, there is a need for global investors to analyze the overall performance of the Australian market as it has been adversely affected by the pandemic (BHP, 2020). Despite efforts for the performance to gradually recover, studies by Yahoo Finance (2020) have shown that there is still a holding of roughly 82% in the general performance compared to before the pandemic. Analyzing the MSCI ESG ratings shows clear evidence of poor land use, wastes and biodiversity, and toxic emissions that have primarily affected the industrys progress (ESG Ratings, 2020). Corporate Social responsibility is vital and needs to be the center stage for all production companies globally to eliminate the possible impacts of environmental degradation. Therefore, global investors may divert their attention to other companies upon realization of the poor performance of the company in this sector (McCauley, 2012). The poor addressing of issues related to ecosystem and pollution may heavily affect the companys global image in the long run.

ESG Ratings

Environmental, Social, and governance (ESG) criteria are vital standards for a corporation operation that investors analyze before investing their shares to realize potential profits. Environmental criteria are used to evaluate a companys performance concerning nature (Galbreath, 2013). On the other hand, social criteria examine how the company manages its relationships with its customers and suppliers; employees are the community they operate (Friesen, 2013). Governance evaluates the companys shareholders rights, internal controls, audits, executive pay, and then the companys leadership form.

As an ESG-specialist, there are various aspects related to the environmental, Social, and Governance aspects that I must assess in the ESG ratings of the Australian Materials sector. For instance, based on ecological factors, the key factors that I will determine entail the companys energy use, waste, and natural resource conservation (Allen et al., 2013). These factors may also be used to analyze the environmental risks that a company may be facing and suggest the possible ways that the company may adopt to manage such risks (Campbell & Slack, 2019). For instance, on an analysis of the MSCI ESG ratings of BHP, there is clear evidence of poor land use, wastes and biodiversity, and toxic emissions that have primarily affected the industrys progress (ESG Ratings, 2020). Global investors may divert their attention to other companies upon realization of the companys poor performance in this sector. The poor addressing of issues related to ecosystem and pollution may heavily affect the companys global image in the long run.

Social factors analyze the companys business relationships with customers, suppliers, and investors. Factors that should be considered include the relationship that the company has established with the local community through the donation of a smaller percentage of their profit to them, motivation of their employees, and holding the same values with their suppliers. For instance, Rio Tinto has established well-functioning regard for its employees health and safety with much focus on the stakeholders interest being taken into consideration (Tinto, 2015). On the other hand, Fortescue Metals Group offers its employees educational and training opportunities to improve their job skills and has well-established workplace policies related to inclusion, diversity, and sexual harassment (Moodys, 2020). BHP corporation has also ensured fair wages for its employees and assured financial support for higher educational attainments.

Additionally, investors might want to know various factors related to governance, mainly how the company uses transparent and accurate accounting methods and the inclusion of investors in different issues. Investors may also require assurance that the corporation will avoid the conflict of interests in their choice of board members, do not engage in illegal business, and incorporate political aspects in running the company (Tamimi & Sebastianelli, 2017). Therefore, companies should adopt diversity in their choice of board and embrace corporate transparency. For instance, Rio Tinto has established corporate governance whereby they have a joint board of directors. In addition, the company is managed as a single economic unit despite the difference in legal entities and share registers.

References

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Allen, D. E., Singh, A. K., & Powell, R. (2013). Analyzing the return distributions of Australian stocks: the CAPM, factor models, and quantile regressions. Global Business and Economics Review, 15(1), 88-109.

Bauer, R., Otten, R., & Rad, A. T. (2018). Ethical investing in Australia: Is there a financial penalty? Pacific-Basin Finance Journal, 14(1), 33-48.

Baur, D. G., & Trench, A. (2020). COVID-19 Infection of Australian Companies. Available at SSRN 3609110.

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