Intrinsic rate to the financial instrument

[IFRS2020]

My query relates to the intrinsic rate to the financial instrument - say a contract charges interest based on the risk-free rate plus a margin; what would be the intrinsic rate to the financial instrument - will it be the risk-free rate without the margin or with the margin?

Thanks in advance.

[JakobLavrod]

It depends on the measurement model used in IFRS 9. For amortized cost, the matter is actually quite delicate. The common usage is that you at origination use the contractual rate (as long as there are no other special features such as prepayment or fees that alter the cash flows) and then if the risk free rate changes, you can just adjust the rate with it.

It is considerably more technical if you have some components that reprice with the risk free rate and some that does not. In that case, if one were to go by the book, you have to compute a new EIR each time the risk free rate change by finding which rate discounts the new cash flows to the current gross carrying amount.

Finally, if one wants and even more elaborate solution (which only a few uses), one could move from spot rates to forward rates, and compute the EIR by setting cash flows based on forward rates (so that one makes a prediction on what the cash flows will be). In this scenario, as long as the risk-free rate develop as the market expects, your EIR will remain constant, and only change due to changes in market expectations on future rates. While this latest one might be conceived as the solution that most fully incorporates future cash flows and time value of money, it is also clearly the most technically advanced.

[Marek Muc]

What's 'intrinsic rate'?

[IFRS2020]

The instrument is measured at fair value through profit or loss.

It is not clear what is the intrinsic rate - will it be the risk-free rate without the margin or with the margin? Is there any guidance on this?

[Marek Muc]

Before we dive into the calculations, can you simply define it to me?
What are you planning to use it for?

[IFRS2020]

to use it as a discount rate for the net present value calculations

[Marek Muc]

So you're trying to measure fair value of an unquoted debt instrument using a present value technique, is that right?

[IFRS2020]

Yes Marek, that is correct.

[Marek Muc]

I see, I've never really come across 'intrinsic rate' in this context or any other, to be honest. What you should do is discount the cash flows using a market interest rate. Basically, take the risk-free rate, add the credit spread and any other relevant risks, like liquidity risk. A good tip is to look up a quoted bond from a similar issuer with similar maturity and use its yield as your baseline.

[IFRS2020]

Thanks for the quick response.