We are working on a new tool for our CFO.tools platform. It will calculate the effective interest rate (EIR) based on the assessed cash flows related to loan exposures.
While EIR is often an overlooked parameter in ECL calculations, it may actually be quite important – especially in times of significant changes in interest rates when the exposures have fixed agreed rates, or in cases of bonds under distress (but not defaulted). In the latter case, the fair value of the exposures acquired may be significantly lower than the par value.
Let us look at a simple example: imagine a three-year bond with a 5% annual coupon rate and a par value of CU 100, currently sold at CU 70. Assuming CU 70 is the fair value of the exposure, one should have the gross carrying amount of the exposure at 70, as required by IFRS 9, and then use the effective interest rate method to assess the gross carrying amount and the interest for the periods until maturity. Under this somewhat simplified case, one may calculate that the EIR would be approximately 19%, which would significantly change the evolution of the gross carrying amount over time and the revenue recognised at the end of each of the following three reporting periods.
