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Understand the “investment grade”


    Shall we understand the investment grade?

    Every now and then, there is something in the press about Brazil's credit note and the so-called investment grade.

    In this article, I will show you how this process works and what the role of risk assessment agencies is.

    Government financing needs

    All governments in all countries demand resources to finance their development projects. In addition to the collection that each country has, through taxes, these resources are obtained through loans made by investors to each of these countries, in exchange for an interest rate.

    Any investor can purchase debt securities from a specific country and receive interest for that, according to the rules established by the chosen security. Here in Brazil, for example, the investor does just that when he chooses to invest in direct treasury bonds: he lends money to the country to receive interest in return.

    The risk scale

    Once the need for financing exists, it is necessary to define then what would be the interest rates of each country. Of course, each country can set its interest rates according to its internal conditions, but these rates need to make sense when compared to a global scale, otherwise, investors will not be interested in investing in countries whose interest rate is not consistent with their reality.

    Therefore, there is a global reference scale that measures the level of risk in each country. This risk is the risk that a country eventually, in the face of a serious crisis, will not be able to honor its debt payments to investors. It is precisely the perception of risk that will translate into an interest rate compatible with each country.

    Thus, by defining the level of risk for each country, the international financial market is positioned in relation to the decisions to invest or not in the respective debts, according to the opportunity cost they represent.

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    For example:

    Brazil's risk of defaulting on its debt today is low. However, however low, the risk that Norway, Sweden, the Netherlands or Australia will default is even lower. Therefore, on a risk scale, these countries will have better grades. Thus, an international investor will not invest in Brazil if its rate is equal to those of these countries. He needs the Brazilian interest rate to be higher, otherwise it wouldn’t make sense to earn it at a higher risk.

    The risk of Norway, Sweden or the Netherlands defaulting is very low. However, however low, the risk that England, Germany or the USA will default, is even less! Soon their credit notes will also be smaller and so they will be able to raise funds from investors by paying lower interest rates for that.

    Then, all countries receive their credit notes and position themselves on that scale. Naturally the countries with the best score, considered the best payers and the least risk, will be able to raise funds with lower interest rates and the countries with the worst score, considered not as good payers and with the highest risk, will necessarily have to pay higher interest rates to investors.

    Risk agencies

    This rating process is carried out by companies specialized in assessing the countries' financial health and thus assigning their ratings.

    The 3 largest risk rating agencies are: Moody's, Standard & Poor's (S&P) and Fitch.

    Risk scales according to each agency

    There are 10 major groups on the risk scale. In order of the best grades for the worst grades we have the following groups:

    > Prime
    > High grade
    > Medium high
    grade> Low medium grade
    > Non-investment / speculative grade
    > highly speculative
    > Substantial risk
    > extremely speculative
    > in default with little expectation of recovery
    > In default

    These 10 large groups are subdivided by the agencies into even more specific notes as you can see below:


    The investment grade

    The grades awarded from the “low medium grade” level upwards (including him), comprise the so-called “investment grade” group. The importance of staying in this group is as follows:

    Billions and billions of dollars are managed in the financial market from funds invested in pension funds, investment funds and so on. This is the “bulk” of the financial volume. However, most of these funds provide in their regulations for a ban on investing in countries below “investment grade”.

    Thus, countries that score below this level, are extremely affected in raising funds and this hinders their entire development, in addition to the need to maintain much higher interest rates to compensate for the level of risk they are associated with. Therefore, the situation becomes extremely unfavorable and the economy feels this impact immediately, with reduced investments, unemployment, and recession and so on.

    To lose the so-called “investment grade”, a country needs to have at least 2 of the 3 agencies rating below the “low average grade” level.

    Example of the notes today, 07/28/2015

    Below is an example of the notes of some countries, including Brazil, so that you can see what the scale looks like.

    Perhaps at this point, the situation will be different, depending on when you are reading this article, but the figure serves as an illustration to help your understanding:


    In the first column are countries. In the second, the CDS of several countries on the date of 02/02/2015 and in the third column the CDS on the date of 28/07/2015.

    CDS (Credit Default Swap) is an instrument used in the fixed income market that can be used to express a country's credit risk. The higher the CDS, the greater the perception of risk in a country.

    In the table above, you can check the CDS of various countries as of 07/28/2015 and the respective notes assigned by the risk rating agencies.