Guidance on calculating the implicit interest rate for service concession arrangements
Introduction
The implicit interest rate is necessary to reflect the financing aspect of the service concession arrangement. Paragraph 6.2.39 of the iFReM requires the grantor to use the long-term risk free rate. The purpose of this guidance is to help you determine the appropriate rate to use in service concession arrangements. The formula for working out the market risk-free rate is illustrated below.
Assumptions
It is assumed that the contract is a service concession arrangement and commenced on 30 April 2008.
Determining the implicit interest rate
The correct implicit rate to use should be the UK’s long-term real interest rate. The rate can be found in the Monthly Interest Rates table on the FReM website. This table only provides the rate upto April 2008 and after that you will need to calculate this using the formula given below. As the contract commenced in April 2008, the long-term real rate was 1.6 % - see column 4 of the ‘Long Term Real’ at the end of the table. Suppose that the Monthly Interest Rate table was not available. How would you calculate the long-term real interest rate? The same rate used above can be calculated using the formula below: 1 + nominal interest rate/ 1 + inflation rate = 1 + real interest rate In order to get the inflation and interest rates, you can use HM Treasury’s Pocket Data Bank which is also available via FReM website. The two tables that are required for this particular calculation are Table 16 and Table 26. In Table 16, you will find the inflation rate, which for April 2008 is 3 % (CPI) and in Table 26 you will find the long-term interest rate, which again for April was 4.6 %. Using the formula above the rate is calculated as follow: 1.046 (the nominal interest rate) 1.03 (the inflation rare) = 1.0155
The real interest rate therefore is 1.6%, which is same as the rate used in the Monthly Interest rates table. This rate of 1.6% could have been arrived at by using the approximation rule i.e. 4.6% less 3% = 1.6%. However, this is not technically correct nor would it work if the two rates were significantly different, for example, say the interest rate was 15% and the inflation was 10%, using the approximation rule, the rate is 5 % but applying the formula the answer you get is 4.5%.
Guidance on calculating the implicit interest rate for service concession arrangements
Other comments
There may be occasions when you might not find the relevant information in the HM Treasury’s Pocket Data Bank due to timing differences. In such situation you may wish to wait until the data is available or obtain the data from other sources. Given that this is a weekly publication it is unlikely this will be an issue.