The Fair Value DCF is calculated based on the discounted cash flow method. This method takes into consideration all risks associated with financial instruments. These include:

- cash flow timing and variability,
- benchmark market rate risks,
- credit risk (captured through credit spread),
- credit risk mitigation instruments,
- risk of embedded options (captured either through option pricing models or on a retail portfolio level through e.g. prepayment curves),
- liquidity and operational costs (acquired through an initial residual spread incorporated in the discount rate).

The discounted cash flow method derives the fair value of a loan at time *t* via

where *CF(t _{i})* are the expected future cash flows of the loan. A fair value calculated with the discounted cash flow method differs from the classical present value through the rates used in the discounting: While the classical present value only incorporates the market interest rate, the

**discount factor**

*DCF(t*incorporates all of the following elements:

_{i})- market interest rate
- credit spread and collateral enhancement weighting coefficient
- initial residual spread

To be more precise, the discount factor at payment date *t _{i}* used in the calculation of fair value is obtained by

where

*MR(t*denotes the market interest rate at payment date_{i})*t*,_{i}*CS(t*stands for the credit spread of the counterparty at payment date_{i})*t*,_{i}*CEWC(t*denotes the collateral enhancement weighting coefficient of the deal at payment date_{i})*t*,_{i}*InRS(t*stands for the initial residual spread of the deal conclusion date_{0})*t*and_{0}*Δ**(t*denotes the time gap between payment date_{i},t_{0})*t*and deal conclusion date_{i}*t*._{0}

Deriving the fair value using the above formula for the discount factor leads to the calculation of a **fair value**.

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