Pricing and Hedging of Contingent Credit Lines

Abstract

Contingent claims theory has given us the technology for pricing and hedging a broad array of derivatives securities. But it also provides the means to evaluate options that are embedded in non-derivative instruments like callable bonds and mortgages, as well as options that are not connected to traded securities at all, such as „real options.” A bank line of credit, or „contingent credit line”(CCL) gives a borrower the option to take down a loan on demand, at a precommitted interest rate, or rate spread relative to a base rate. However, the borrower's option is limited by the bank's option to refuse the loan if the borrower's credit quality has fallen below a specified level. The contingent payoff to the CCL resembles that of an interest rate cap that is knocked out if it gets too far in the money. In this article, the authors model the various contingencies to develop a pricing and hedging methodology and analyze the sensitivities of a CCL to the model parameters.