FlexFinance
Page tree

Versions Compared

Old Version 1

changes.mady.by.user Ethan

Saved on

compared with

New Version Current

changes.mady.by.user Ethan

Saved on

Key

  • This line was added.
  • This line was removed.
  • Formatting was changed.

...

Expand
titleInitial 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.

  • risk-free market rate
  • credit spread
  • risk reserve for liquidity risk
  • profit centre margin

Due to the following reason, knowing the InRS is important in the accounting world:

  • 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.

Basically, the idea of the InRS is that it will be calculated only once at the beginning of the lifetime of a financial instrument. However, the following situations can be seen as comparable to the “birth” of a new financial instrument so that the InRS has to be recalcualted:

  • restructuring of the financial instrument
  • buying a long position and selling a short position of a bond


Expand
titleExample of calculating an InRS

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 1: We calculate the EIR of the deal by performing a goal seek on the sum of the EIR discounted cash flows (Columns D, E).

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 eal.


...