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Market Volatility and Financial Covenants
by Stephen Walter, Structurer, Commerzbank Corporates and Markets
The financial markets tumult has left many corporates facing a series of challenging decisions; arguably none more so than the negotiation of funding or the maintenance of existing credit lines. With recent reports highlighting the onset of tighter financial covenants, to what extent will financial covenant ratios be impacted by the increased market volatility?
International Financial Reporting Standards requires all derivatives to be fair valued through the income statement
It can be argued that a financial covenant’s primary role is to forewarn the onset of financial difficulty - the latter often appearing in the form of an unmanageable exposure to risk. The flagging of a potential breach allows action to be taken by both lender and borrower to address the issue.
Ratio analysis is the most common method of policing the covenant - an area customised to accord both the lender’s and borrower’s requirements. Examples of financial covenant ratio categories are:
These ratios serve well in times of low market volatility (as the underlying business and degree of market risk accepted are the primary drivers of change). In times of high volatility, however, the following ratios in particular, bear a significant exposure to market risk reporting that is fair value / quasi fair value change:
- Debt to Equity Ratio
- Total Debt to Total Asset
- Debt to EBIT
In each case, the numerator and the denominator has the potential to be impacted.
The first section of this article assesses the extent to which this might be an issue by comparing the degree of recent market volatility to prior periods. The second makes use of a case study to compare the potential 2007 and 2008 reporting period. Actual market volatility has been applied to the latter.
Exchange Rate, Interest Rate and Commodity Market Movements
Figure 1 of Appendix B demonstrates the unprecedented quantum and speed of Sterling’s depreciation against the Euro during 2007 / 2008; a 42% decline between June 2007 and December 2008. The next recorded depreciation of this magnitude occurred in the 2nd quarter 2003, a mere 15%.
The average exchange rate fell 17% from 2007 to 2008, the largest movement on record.
In 2007/2008, Sterling depreciated by approximately 27% against the US dollar (refer Figure 2 in Appendix B); the last time an equivalent depreciation was recorded was at the beginning of 1994.
The average exchange rate fell by 8% from 2007 to 2008 - following on from an 8% appreciation in average sterling value from 2006 to 2007.