There are a number of possible models for estimating the expected loss and capital requirement. Popular pricing models for this approach work on the premise that financial guarantees are equivalent to another financial instrument and pricing the alternative, for example, treating the guarantee as a put option and using option pricing models, credit default swap pricing models, etc. For instance, publicly available data of credit default swaps spreads may be used to approximate the default risk associated to the borrowing and, therefore, the guarantee fee. When using this type of data, the identification of the default event (e.g. bankruptcy) is central to the comparability analysis between the controlled transaction and the potentially comparable credit default swap (See Section C.1.2, on the reliability of credit default swap data).
TPG2022 Chapter X paragraph 10.179
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By OECD
Category: OECD Transfer Pricing Guidelines (2022), TPG2022 Chapter X: Transfer Pricing Aspects of Financial Transactions | Tag: Cost approach, Expected loss approach/method, Financial guarantee, Financial transactions, Loan guarantee, Pricing guarantees, Spreads of credit default swaps, Treasury functions
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- TPG2022 Chapter X paragraph 10.180Pricing under each model will be sensitive to the assumptions made in the modelling process. Whatever valuation model is used, the evaluation of cost method sets a minimum fee for the guarantee (the minimum amount that the provider of the guarantee will be willing to accept) and does not of...
- TPG2022 Chapter X paragraph 10.181The valuation of expected loss method would estimate the value of a guarantee on the basis of calculating the probability of default and making adjustments to account for the expected recovery rate in the event of default. This would then be applied to the nominal amount guaranteed to arrive at...
- TPG2022 Chapter X paragraph 10.178This method aims to quantify the additional risk borne by the guarantor by estimating the value of the expected loss that the guarantor incurs by providing the guarantee (loss given default). Alternatively the expected cost could be determined by reference to the capital required to support the risks assumed by...
- TPG2022 Chapter X paragraph 10.182The capital support method may be suitable where the difference between the guarantor’s and borrower’s risk profiles could be addressed by introducing more capital to the borrower’s balance sheet. It would be first necessary to determine the credit rating for the borrower without the guarantee (but with implicit support) and...
- TPG2022 Chapter X paragraph 10.177The result of this analysis sets a maximum fee for the guarantee (the maximum amount that the recipient of the guarantee will be willing to pay), namely, the difference between the interest rate with the guarantee and the interest rate without the guarantee but with the benefit of implicit support...
- TPG2022 Chapter X paragraph 10.176The benefit of implicit support will be the difference between the borrowing terms attainable by the borrowing entity based on its credit rating as a member of the MNE group and those attainable on the basis of the stand-alone credit rating it would have had if it were an entirely...
- TPG2022 Chapter X paragraph 10.175The next step would be to determine, by a similar process (unless directly observable in the case of a loan from a third party), the interest rate payable with the benefit of the explicit guarantee. The interest spread can be used in quantifying the benefit gained by the borrower as...
- TPG2022 Chapter X paragraph 10.174This approach quantifies the benefit that the guaranteed party receives from the guarantee in terms of lower interest rates. The method calculates the spread between the interest rate that would have been payable by the borrower without the guarantee and the interest rate payable with the guarantee. The first step...
- TPG2022 Chapter X paragraph 10.173An independent entity providing a financial guarantee would expect to receive a fee to compensate it for the risk it is taking in accepting the contingent liability and to reflect any value it is providing to the borrower in respect of the guarantee. However, it must be borne in mind...
- TPG2022 Chapter X paragraph 10.172The difficulty with using the CUP method is that publicly available information about a sufficiently similar credit enhancing guarantee is unlikely to be found between unrelated parties given that unrelated party guarantees of bank loans are uncommon....