Financial Guarantee Contract - discounting

[hubertd]

Hi Everyone,

I've been looking for this information everywhere and asking quite a few people without any success. Would anyone know what discount rate to use in order to calculate present value of the premium fees when recognising the liability for financial guarantee?

[JakobLavrod]

I think this example demonstrates the calculation:
https://www.bdo.com.au/en-au/content/ac ... der-ifrs-9

In this example, the premiums get discounted under the discount rate the borrower would have had without the guarantee, which sort of make sense in that one can consider it as the guarantor "giving" a loan to the borrower, which lowers the interest rate they have to pay. When looking in the standard paragraph 4.2.1 (c) references 5.1.1, which states that one should use the fair value, so there is an argument then to be made for using the discount rate the borrower can get in the open market without the guarantee, but I have never worked with these types of instruments myself, so would love input from someone else here

[Marek Muc]

Makes sense to me!

[DJP]

I also agree. It makes sense to use the borrower's normal borrowing rate (without considering the guarantee). If the borrowers defaults, the guarantor will reimburse the lender and then will claim the money from the borrower. Therefore, the premium should reflect the borrower's risk, because that's the risk the guarantor is exposed to.

[hubertd]

"Therefore, the premium should reflect the borrower's risk, because that's the risk the guarantor is exposed to." Borrower's borrowing rate is not equivalent to borrower's risk. Also, how would you translate a floating borrowing rate into a discount rate? Not only is it based on changing benchmark but the margin is quite often adjusted over the duration of the loan (ratchet).

[JakobLavrod]

Good points raised hubertd. What I meant was that the borrowing rate includes a risk premium that reflect the borrowers risk. For floating rate, one possibility is to use not one discount rate, but rather a forward curve. Hence what you could do is question solving, so that you assume the initial amount is X, and then using the forward curve let this amount accure interest, and ne you get to a premium, subtract that of the balance, in such as way that in the end you get 0. This is exactly the calculation which would have resulted in using the EIR as the discount rate, had interest been fixed. Another alternative is of course if one can find what fixed lending rate to use.

[hubertd]

Thanks Jacob. I'm aware of the concept and applicability of forward curves. Although they are hardly ever used to construct discount curves for financial reporting use (more applicable to calculate FV of derivatives) this is definitely one of the options. I think adjusting risk free rate (yield of gilts of equal maturity) with borrower specific risk adjustment would indeed be the best approach.

[DJP]

It is obvious that the borrower's borrowing rate must reflect the borrower's credit risk.

How to go about this, that's a different question. And yes, you will have to adjust a risk-free rate with the borrower's credit risk. Your Transfer Pricing or Treasury team should be able to assist you (in case you have such teams).

[hubertd]

Thanks guys for your comments.