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- External approach: The entity delivers the credit spread curve which includes the collateral information. In this case, the CEWC will be set to a value of 1.
- Internal approach: The entity delivers the CEWC figure, and the solution takes it into account in the valuation.
- Advanced internal approach: Based on the information delivered for collateral instruments , the solution calculates the CEWC.
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For the adjustment of the credit risk related part of the DCF the following steps have to be carried out:
Step 1: By retrieving the credit spread curve from customer rating and the credit spreads from the time gap, credit spreads for each cash flow are determined: Step 2: Colalteral is valued and the corresponding CEWC is computed in relation to the outstanding payment for the deal:
Step 3: Adjusted credit spreads are determined as the product of the original credit spread and the corresponding CEWC: |
Initial Residual Spread:
The initial residual spread (InRS) is a constant value which is calculated as a residual amount on the deal conclusion date. The InRS is calculated so that, on the deal conclusion date, the fair value of the deal on the start date corresponds to the cost of purchase, i.e. on the deal start date, the sum of the discounted cash flows corresponds to the cost of purchase. When the “price” of a financial product (e.g. a loan or a bond) is determined by the bank, several components are taken into account, e.g.
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- For the representation in the balance sheet and P&L for IFRS, only the market rate and the credit spread are of interest. These portions will be determined by calculating fair value changes.
- Fair value changes are a function of the variables MR, CS and InRS for which the fluctuation of the risk-free interest rates, the credit spreads and the initial residual spread are of relevance.
- Therefore, the rest of the components (e.g. liquidity risk reserve, profit centre margin etc.) will be bundled together and named “Initial Residual Spread”:
Hence, the InRS can be understood as the profit margin of a deal.
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- restructuring of the financial instrument
- buying a long position and selling a short position of a bond
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In general, in customer business, the initial residual spread of a deal is determined by the bank and has to be delivered. If the InRS is not delivered for a deal, it can be calculated by the solution on the basis of the expected cash flows CF(ti) for the deal, the market rates MR(ti) and the corresponding credit spreads CS(ti) and collateral enhancement weighting coefficients CEWC(ti). To be more precise, in view of the discounted cash flow method, the InRS is calculated so that the mark-to-model fair value of the deal (i.e. the sum of the discounted cashflows) equals its original costs at deal origination date. This is performed by implicitly solving the following non-linear equation with a Newton iteration:
For instance, a concrete situation of calculating an InRS is shown by the following data (columns A, B, C): Step 2: We enter the market interest rates, credit spreads and collateral enhancement weighting coefficients for each cash flow (Columns F, G, H). Step 3: We calculate an "unweighted InRS" for each cash flow (Column I). Step 4: We calculate the InRS for the deal by performing a goal seek on the sum of the FV discounted cash flows as described by the above formula (Columns J, K) As a matter of fact, Steps 1 and 3 are not needed in order to derive the InRs of the deal – they only serve as a comparison between the "unweighted InRSs" per value date with the (global) InRS of the deal. |
