The main challenge does not stem from the mathematical formula but from the cash flows to be considered for EIR calculations:
- Systems for retail business do not have cash flows.
- Systems lose historical cash flows (real cash flows).
- Systems cannot calculate future floating cash flows.
- Systems cannot distinguish between EIR relevant and irrelevant cash flows.
- Systems cannot consider prepayment behaviour (only contractual cash flows).
- Systems cannot handle complex fixing agreements.
The solution has to calculate the amortisation plan over the complete lifecycle of a deal and to provide separate amounts for all relevant cash flows, including
- premiums, discounts and upfront payments
- transaction costs
- forward adjustments
- costs of embedded separated from the host contract
- hedge adjustments at the termination of a hedge relationship
- initial basis adjustments for late hedges
- unwinding of the impairment adjustment
A further challenge is to know when the EIR has to be recalculated:
- No recalculation of EIR in the following cases:
- Not because of unexpected capital changes such as partial notional redemptions!
- Not because of an impairment!
- EIR has to be recalculated in the following cases:
- For floating-rate products at the new fixing date.
- For credit lines at each drawing.
- For security long positions at each buying transaction.
- After a contractual change or new estimation of the repayment plan.