BUS326 Lect 11 Risky Debt and Option Pricing - CREDIT RISK AND OPTION PRICING(Adapted form Pennacchi G(1992 Lecture Notes University of Illinois College

BUS326 Lect 11 Risky Debt and Option Pricing - CREDIT RISK...

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Unformatted text preview: CREDIT RISK AND OPTION PRICING (Adapted form Pennacchi, G. (1992), Lecture Notes, University of Illinois College of Commerce and Business Administration.) Bank Loans and Option Pricing Goal: to calculate a “fair” interest rate on a bank loan to a borrower with the following characteristics. (A1) Loan 1s a single payment (bullet) loan paying the principal plus interest of $X 1n 1: periods ~ (A2) Right after the loan is made, at time t, the borrower -. - has assets worth $A(t) that back the loan. Comment: $A(t) is the time t-wvalue of those assets that the bank can legally seize (foreclose on) if the borrower- defaults on the loan at time t + 7:. For a securedloan, $A - is the value of collateral. For an unsecured loan to an all eguity firm $A is the entire firm s assets For a mortgage loan, EBA 1s the value of the house (A3) The variance of the rate of return on the.$A of assets is 0'2 per unit time. (A4) The assets have a payout rate of u. Examples (1) If loan is to an all equity firm, u may be the dividend payout rate to stockholders. (2) If assets are physical capital, it could represent the depreciation rate. (A5) The riskwfree rate of interest = 7" per unit time. Let D(t) denote that (market) value of this loan at time t. Then the loan’s value at maturity, D(t + r) is D(t + a = Minix, Av + at : X m. MaX[0, X — AU + T)] Equation“) says the valueiof a risky lean at maturity equals the value of a risk'vfr‘iee loan, X, minus the value of a put option on the value oi” the assets backing the loan, A(t + r), and having an exerCise price of X, cf. writing put option and writing (selling) loan insurance. Limited—liability of the borrower essentially means that the borrower has purchased the right (option) to sell the assets backing the loan, AU), back to the bank at the price X. Thus the value of the risky loan prior to maturity is the value of a risk-free loan minus the put option. D0) = Xe“ - P(A(t), X, r) (2) : Xe” - {Xe‘m N(-d2) fl A61” N(*d1)} = Xe“ mag) + Adm N(—d1) If this loan is made at its initial fair value, DU), then its fair yield to maturity is defined as D0) = Xe'R". Hence R : iii-[L] 1:" ‘ DU) (3)77 A Numerical Example Calculate the breakweven interest rate a bank would have to charge on the following firm’s loan. (a) The loan has a two year maturity with no interim payments. 1' = 2 years (b) The payment at maturity (principal + interest) is $4 million . =$4 (c) The bank’s marginal cost of funds (cost of two year fixed rate financing) including its marginal cost of monitoring, is 7%. I R: 0 07 (d) The value of the firm 5 assets backing the loan currently equals $7 million. The firm IS not expected to make any payments out of these assets over the life of - _ the loan. A: 7 .r (e) The annualised variance of the rate of return on these assets of the firm is 20%. 02 = 0.20 SOLUTION: D(t) m {RISK FREE LOAN} — {PUT OPTION} = Xe” — {Xe‘rr N(-—d2) — Ae‘m N(-d1)} d = I 0%. ln[l]+ 0.'(7)7:7+—Q'2— x2 d ..... 4 2 1 00.2035 511: 0.5596+0.3§;00 21.42. . 0.6325 d2 2 d1 ~m/?-..-4=1.42 #06325 d 2 m 0.79 N(d1) = 0.9222 N909) = 0.0778 DU) 2: 4.50M2 —— {46”0'O7X2(0.2148)m 7.(1)(0.0778)} = 3.48 ~ {0.75 — 0.54} D(t) = 3.27 3.279;"?2 m 4 R 21111 mi] 2 3.27 R 210.08 BREAK EVEN INTEREST RATE m 10.1% SAY "EECOLLATERALIZED LOAN * , _::::> REPAY LOAN WITH CERTAINTY BUT ALSO gRETAIN PUT TO SELL COLLATERAL TO LENDER. A AWHEN WILL YOU SELL?? . ‘ ~'7j-‘§SELL WHEN COLLATERAL AT MATURITY < ' LOAN VALUE , ...
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