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The government X issues a guarantee for N years to provide funding for a given economic sector. Then, the bank Y provides funding to companies operating in such economic sector with the guarantee of the government X.

Let's take the perspective of X that wants to calculate the expected loss on this portfolio: what interest rate should it use to discount losses?

In the asset case the rate should incorporate the uncertainty of being paid (i.e. the credit risk). In this case, being liabilities, I feel the evaluation should not consider credit risk because, from the perspective of X, the losses must be repaid to the bank Y; therefore I'd discount losses with risk-free.

Is it correct?

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  • $\begingroup$ @Alper I'm sorry but it is not written anywhere that the government is going to decide the sector to invest in based on the NPV. It is a general question to understand how to select the interest rate to discount these outflows/losses. You can replace the government with a bank or an insurance company or a re-insurer $\endgroup$
    – Nassir Bin
    Jan 13 at 14:57

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Your approach is largely correct.

Since the government X is guaranteeing the loans, the risk of default is essentially transferred from the companies to the government. Therefore, from the perspective of government X, the expected losses should be discounted at a RFR. This is because the government is obligated to cover these losses regardless of the credit risk associated with the companies.

In loan portfolios, the interest rate incorporates the credit risk of the borrowers. However, in this scenario, since the government guarantee effectively removes the credit risk from the equation (from the perspective of the bank Y), the credit risk is not a relevant factor for discounting the expected losses for the government.

Hope this helps.

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  • $\begingroup$ thank you. More in general: if I need to evaluate the PV of all in and out cashflows, obviously you'll discount the inflows with the credit risk of the counterpart; is it correct that I'll discount my outflows at RFR? $\endgroup$
    – Nassir Bin
    Jan 16 at 8:53
  • $\begingroup$ Yes, I believe. It works because outflows represent your own payments, which do not carry credit risk from your perspective. Discounting these outflows at the RFR accurately reflects their time value of money without the unnecessary addition of a risk premium for credit uncertainty. $\endgroup$
    – Nikolai
    Jan 16 at 17:23

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