Credit Exposure and Valuation of Revolving Credit Lines

Abstract

A revolving credit line is one of the most common forms of commercial bank loan. Fixing the interest rate and the maximum loan amount but not the utilization pattern introduces several types of uncertainty into the contract. In practice, in addition to the interest on the drawn amount, a variety of different fees and charges may be imposed, although generally not all at once. This leads to interesting optimal behavior for the borrower in the face of stochastic fluctuation in market interest rates and borrower credit quality. For example, the borrower can raise funds in the open market if the interest rate is lower there but has the option to draw against the line at the original rate if its creditworthiness weakens. Jones and Wu present a model incorporating these special features and explore how they affect optimal loan terms and borrower behavior. Interesting results include the fact that because of the borrower’s option to draw on the credit line when its creditworthiness weakens, the lender cannot make money on the deal without incorporating extra fees on top of the interest on the borrowed principal.

TOPICS: Real assets/alternative investments/private equity, quantitative methods