Contractual Cash Flows

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Definition

For any financial contract, Contractual Cash Flows (also Scheduled Cashflows) denotes the cash (money) exchanges between the contracting parties as stipulated in the contract documentation (loan agreement, term-sheet, prospectus etc.)

Usage

Contractual cash flows play a fundamental role in the functioning of the financial system. They (among many other usages)

  • define the monetary implications of contracts
  • are the basis for establishing economic value
  • form the legal basis for establishing Credit Event
  • form the basis for accounting treatment under IFRS 9 (via the SPPI test)

Categorization

Contractual cash flows are specified in some form in almost all economic contracts, hence there is a enormous variety. Some useful categories:

  • by the degree of cash flow certainty. (The certainty here refers to what is stipulated in the defining term-sheet, not any Risk Factor associated with the future realization of cash flows.). In turn the degree of (un)certainty can be categorized as
    • linked to the intrinsic objectives and design of a financial contract (e.g. equity versus debt instruments)
    • linked to indirect uncertainty (e.g. reference and linkage of cash flows to external market variables or events)
  • by the frequency of the schedule
  • by the grouping of cash flows (e.g. into principal or interest payments) and other possible conventions that shape the repayment schedule
  • by the amortization profile of the cash flows

Equity versus Debt Cash Flows

Broadly speaking financial contracts can be separated into two major categories

  • where cash flows are not certain and not specified in any detail (Equity / Share like instruments)
  • where cash flows have a large degree of certainty and specified in some detail (Fixed Income like instruments), even though they might not be deterministic (fully specified) - e.g. may depend on interest rate benchmarks

Debt Instrument Cash flows

For debt instruments there is standard separation of cash flows into principal repayment and interest payment cash flows. This division does not necessarily have intrinsic monetary significance (it is primarily a cultural convention)

Principal Repayment Cash flows

Principal repayment cash flows denotes the precise Amortization Schedule by which an originally borrowed amount (Principal) is repaid over a period of time. Potential repayment options include:

  • Linear amortization (also straight line amortization)
  • Annuity style amortization (including interest payments)
  • Final lump sum (balloon payment)
  • Negative amortization (growing balances)
  • Custom profile

Interest Payment Cash flows

Interest payment cash flows denotes the precise schedule by which interest on the originally borrowed amount (Principal) is paid over a period of time. Potential repayment options include

  • No interest (for a certain period)
  • Regular interest payment (applied on remaining outstanding principal)
  • Custom profile

Fixed Interest Schedule

Where the interest rate is fixed for the duration of the loan or other credit product

Floating Interest Schedule

In the case of floating interest schedule, the interest on the loan is paid periodically (monthly, quarterly) at a rate specified relative to some reference rate. Loans with floating-rate interest rate payments involve thus cash flows whose absolute values are not known with certainty except until the next interest rate reset.

Example: LIBOR + 250 basis points (L + 250 bp)

Mixed Schedules

Where the nature of the interest rate payments switches between fixed and floating, possibly depending (being contingent) on the realisation of various events

Repayment Frequency

A wide range of options is used, depending on market, product and borrower type.

Regular (periodic) repayments

  • monthly (typically in consumer finance)
  • quarterly
  • semi-annual
  • annual

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