Amortized Cost for Variable-Rate Financial Transactions  

Use

In this function, the system calculates the amortized cost key figure for variable-rate cash-flow transactions, such as floaters and variable-rate loans.

The system contains two methods for amortizing these types of transaction;  both methods are IAS-compliant. Which method is used depends upon whether the premiums and discounts are interest-rate induced, or arise due to the credit rating.

Prerequisites

In Customizing for Bank Analyzer under Processes and Methods ® General Calculation and Valuation Methods ® Fair Value Server ® Configuration ® Edit Environment for Fair Value Server and Set Up Derivations, you have defined whether the system is to calculate the exact effective interest rate for the key date by taking into account all interest rate fixing dates.

In Customizing for Bank Analyzer under Processes and Methods ® General Calculation and Valuation Methods ® Fair Value Server ® Configuration ® Edit Environment for Fair Value Server and Set Up Derivations, you have defined which method is to be used to amortize which types of transactions. You define this in the Amortization for 1^st Fixing Date area.

By specifying the valuation rule you define which method the system is to use to amortize the transactions. Note, however, that you can define how transactions are amortized at financial transaction level only. This means that you cannot use one method to amortize the premium of a financial transaction, and a different method to amortize the discount.

Features

You can use the following methods for the premiums and discounts of variable-rate transactions:

●     Linear amortization up to the first interest rate fixing date

Premiums and discounts are treated as being only interest-rate induced.

The system amortizes the variable-rate cash-flow transactions to the first interest rate fixing date using the linear amortization method. In this method, the acquisition value at the time of purchase is linked to the remaining debt as at the first interest rate fixing date; after this fixing date, the amortized cost up to the maturity of the financial transaction is equal to the remaining debt.

where t is the key date, T₀  is the time point at which the transaction was acquired, T₁ is the first interest rate fixing date, Nom(t) is the remaining debt on the key date, and AV is the acquisition value.

The system uses the linear amortization method only to calculate the amortized cost key figure.

Note the following additional requirements regarding the use of linear amortization up to the first interest rate fixing date. These requirements have to be met by the financial transactions and the data provided by Balance Analyzer:

■      The system processes only simple variable-rate financial transactions such as floaters and variable-rate loans. The system cannot process variable-rate annuity loans.

■      The remaining debt and the acquisition price must be in the same currency.

■      The remaining debt must not change in the first interest-rate fixing period, which is the period up to the first interest rate fixing date.

●     Constant amortization to the maturity of the financial transaction(default setting)

Premiums and discounts are assessed as being based on credit standing; any interest-driven premiums and discounts that occur between two interest rate fixing dates are not considered.

The system amortizes variable-rate cash-flow transactions as fixed-rate transactions but it does not use forward rates to determine the future cash flows. Instead, it uses the reference interest rate that was last fixed.

where AI is the accrued interest, r is the effective interest rate, CF_i is the cash flows at time t_i, and t₀ is the key date or evaluation date.

The latest fixed reference interest rate is used because these transactions are amortized to their maturity, and not to the next interest rate fixing date. The effective interest rate does not change between two interest-rate-fixing periods as a result of continuing the fixed interest. If the transaction data does not contain the fixed reference interest rate, the system takes the reference interest rate from the market data for the evaluation date.

Calculation of the Exact Effective Interest Rate

When you use constant amortization, you can define how the system updates the effective interest rate. If you use the default setting, the system updates the effective interest rate for the current key date by taking the latest effective interest rate.

For variable-rate financial transactions such as floaters, this can lead to inaccurate values in the calculation of the amortized cost and hedge amortized cost if there are interest rate fixing dates between the date on which the effective interest rate was last updated and the current key date. To prevent this, you can activate the calculation of the exact effective interest rate.

When the system calculates the exact effective interest rate, it updates the effective interest rate for all interest rate fixing dates that fall between the latest update of the effective interest rate and the key date. In this case, the effective interest rate calculated on the key date is usually more accurate than that calculated if you do not set the indicator.

Note that if you set the indicator, the calculation process is performance-intensive, which  reduces system performance.

Example

To amortize a group of floaters to the first interest rate fixing date, define a common valuation rule, and in the Customizing for the Fair Value Server environment for this valuation rule, activate amortization to the first interest rate fixing date.