Pricing corporate loans under the risk-neutral measure

Terry Benzschawel, Julio DaGraca and Cheng-Yen Lee

Abstract

ABSTRACT

Corporate loans trade infrequently, and most methods for discounting loan cashflows ignore the effects of default and prepayment and are unable to value revolving loans. To improve loan valuation and risk management, we develop a risk neutral model to value corporate loans and revolving credit lines. The method models the credit-dependent prepayment option and revolver usage patterns using a lattice of risk-neutral credit transitions determined from historical data and modified to be consistent with market prices of credit default swaps. The model calculates average lives of loans, their average times to default, and loan-price sensitivities to market movements.