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Building a Credit Risk Valuation

Framework for Loan Instruments

Scott Aguais, Larry Forest and Dan Rosen

We present a general option-valuation framework for loans that provides valuation

information at loan origination and supports mark-to-market analysis, portfolio
credit risk and asset and liability management for the entire portfolio. We
describe, in detail, the main structures found in commercial loans and the
practical assumptions required to model the state-contingent cash flows resulting
from these structures. The characteristics of the credit risk model necessary to
capture the main features of the problem are described. Finally, we discuss the
families of credit models appropriate for pricing, the data required for their
calibration and reasonable criteria for choosing the sophistication of the model.
We propose a multi-state, ratings-based credit model with three credit drivers: the
credit state of the obligor, the level of risk-free rates and the spreads. Though we
focus primarily on large corporate and middle-market loans, the approach is
applicable more generally to bonds and credit derivatives.

Since its application to derivatives valuation in Since RAROC is not a “no-arbitrage” technique,
the early 1970s, no-arbitrage pricing has become it does not reconcile the prices of loans with
the basis for managing the risk of the trading and those of similar securities available in the market
investment books of financial institutions. No- (such as bonds, other loans and credit
arbitrage techniques are used to price and hedge derivatives). Hence, it cannot assess comparative
securities such as bonds and derivatives, to mark- business opportunities and arbitrage-like
to-market (MtM) portfolios and to measure risk. situations arising from relative price mismatches.
In addition, it is unable to capture the natural
The application of option valuation techniques hedges that often motivate the creation of new
to bank loans has been much slower in credit securities. Finally, while several of the
developing. Most banks today manage the credit financial principles behind RAROC seem
risk of their loan books in fairly simple and generally sound, there are many limitations in its
basically static ways. Perhaps the most prevalent implementation, as has been pointed out in the
method for pricing and managing loans applies literature (Shearer and Forest 1998). For
the concept of RAROC (risk-adjusted return on example, the approach neglects the state
capital). The RAROC approach attempts to contingency of many loan cash flows, takes a
distribute aggregate risk costs down to businesses, static view of credit risk, generally considers an
products customers and, ultimately, individual arbitrary fixed horizon in pricing credit risk and
transactions. Measures of static, marginal risk uses highly subjective parameters in practice.
contributions are used in the RAROC approach
to allocate capital costs directly to individual Many financial institutions today are considering
loans in relation to the firm’s aggregate debt and a move towards mark-to-market approaches for
equity costs. managing their traditional lending business. An

First published in the Algo Research Quarterly, Vol. 3, No. 3, December 2000, pp. 21–46. Forthcoming in the Commercial Lending Review,
Fall 2001.

Enterprise credit risk using Mark-to-Future

MtM approach for loans can facilitate better their application (e.g., Das 1998;
pricing and structuring of credit risky Tavakoli 1998). However, it is more difficult to
instruments, more flexible and dynamic find work that describes the structures of loans,
management of credit portfolios and greater their embedded optionality, the data available for
exploitation of arbitrage opportunities. With pricing these assets and the choice of appropriate
wholesale bank loans, corporate bonds and credit pricing models. Early research in this type of
derivatives together accounting for more than application was performed at Citibank
$30 trillion (all amounts is USD) in exposures (Asarnow 1994; Ginzburg et al. 1994) and was
worldwide, better valuation and risk- continued by Aguais et al. (1998) and Aguais
management techniques hold the potential for and Santomero (1998). While our discussion falls
enormous business benefits. Those who stand to short of a comprehensive survey of loan
benefit the most are the institutions that take instruments, we present a framework that
advantage of an MtM approach to understand incorporates several main structures encountered
the effects of structure and embedded optionality in practice, and describes a consistent approach
on the value of credit instruments. to modelling the underlying risk factor processes.
We present a general option-valuation We lay a tripartite foundation to motivate the
framework for loans. While we focus primarily on general valuation framework:
large corporate and middle-market loans, the
approach is applicable more generally to bonds • The main structures found in commercial
and credit derivatives. This framework provides loans, such as utilization of credit lines and
key valuation information during loan options to prepay. We describe these
origination, and it supports MtM analysis, as well structures and outline the practical
as the portfolio credit risk and asset and liability assumptions required to model the resulting
management functions. state-contingent cash flows.
• The credit model characteristics that are
We emphasize the modelling of key product-
necessary to capture the main features of the
specific features of loans and not the simple
problem. Three factors are generally required
application of a specific type of pricing model to
to model the state contingency of cash flows
the problem. To make an effective choice of
in a reasonable way. These three factors
underlying credit risk model with broad
explain the creditworthiness of the borrower,
applicability, one must understand these features
the level of risk-free interest rates and the
of loans and have an informed practical view of
level of credit spreads. All three factors can,
the market and the data available. While this
in principle, be stochastic.
may seem obvious from a practitioner
perspective, most of the academic literature has • The families of pricing models and the data
steered clear of many of the complications of loan required for their estimation. We discuss
structures. Instead, many papers focus on existing credit models that are appropriate
building new and improved credit risk pricing for these problems as well as reasonable
models, and illustrate their applications with criteria for choosing the model based on a
simple instruments such as straight bonds and trade-off between speed, complexity, data
simple credit derivatives, thereby avoiding many availability and accuracy.
of the details needed in practice, (e.g., Jarrow
The rest of the paper is organized as follows. The
and Turnbull 1995; Jarrow et al. 1997; Madan
next section serves as background, describing
and Unal 1998; Jarrow and Turnbull 2000).
briefly why option-valuation techniques are
These papers offer no solutions to practitioners
gaining practical status and acceptance for loan
choosing and adapting these models to price
portfolios. Thereafter, we present examples of
their generally complex credit instruments, and
loan structures and describe the optionality
calibrating them to available data.
embedded in these structures. The following
One can readily find articles and books section describes various models that capture
describing the features of credit derivatives and these structures and the rationale for several

Credit risk valuation framework

economic and behavioral assumptions. Following transfer of credit risk and the convergence of
a brief discussion of the characteristics of credit markets are compelling financial
appropriate credit risk pricing models, we institutions to manage the risk in the
motivate the use of various families of models, banking and trading books in a more unified
outline the data required and discuss practical manner. The assumption that credit risk can
limitations. As a result, we describe a general not be traded actively is being reconsidered,
framework for implementing these models. and the application of no-arbitrage models
seems more realistic. This trend has led also
Applying option valuation techniques to to the development of pricing and portfolio
credit risk models that integrate market and credit risk
While the application of option valuation to (e.g., Das and Tufano 1996; Jarrow and
securities with underlying credit risk was Turnbull 2000; Iscoe et al. 1999).
originally envisioned by Merton over 25 years ago • Trends in regulation and best practices.
(Merton 1974), it was only in the late 1980s that Although a market-based valuation and
credit risk option-valuation models began to assessment of credit risk is not yet required,
appear in applications. Three main factors both regulatory trends and best practices
contributed to this long delay. First, credit risk point in that direction in the long term. This
modelling is complex and, hence, has trailed is evident from the proposal of the Bank for
behind that of market risk (including equities, International Settlements (BIS 1999) to
foreign exchange and risk-free interest rates). amend the regulatory regime and the various
Second, many have accepted the pessimistic view discussion papers that have appeared in
that the standard assumptions made for response to it, as well as the disclosure of
tractability in no-arbitrage models (such as loan MtM practices by several institutions.
continuous trading, complete markets, no-
frictions and the like) generally do not apply • Improvements in technology. The advent of
when valuing credit risky instruments. Finally, computational technology provides ready
consistent with this view, financial institutions access to non-traditional institutions and
have, by and large, opted for static management investors in the credit markets, and allows
of their (illiquid) credit risks. the application and delivery of more
sophisticated computational tools to price
Financial institutions, however, are being forced and manage credit risk. Furthermore, the
to reconsider these practices and move towards availability of internet tools provides an
MtM approaches for managing their bank loans effective means to distribute on-line credit
for several reasons: information and valuation tools to a large
• Evolution of credit risk markets. The 1990s number of users.
saw the development of stronger bond
markets, secondary loan markets and a Common types of credit instruments
tendency for these two markets to converge. The vast majority of credit instruments involve a
Furthermore, the credit derivatives industry mixture of standard types that lend themselves to
has burgeoned, resulting in enhanced a rather straightforward specification. These
liquidity to support the needs of market types include
participants to transfer credit risk. • bond
• Advances in credit risk models. Several • term loan
decades of research have resulted in a better
understanding of the nature of credit risk • revolver
and in various practical pricing and risk- • financial letter of credit
management models that can be calibrated
• banker’s acceptance
to observable prices and historical data.
• Integration of market and credit risk. The • default swap
advent of credit derivatives to support the • total return swap

Enterprise credit risk using Mark-to-Future

• multi-option facility.
Debt to cash flow Prime LIBOR
General descriptions of these standard credit Level ratio + +
instruments appear in Appendix 1. (bps) (bps)

1 4.75 or greater 250 425

To illustrate the state contingency embedded in
credit instruments, we provide four examples. 2 [4.25, 4.75) 225 400

3 less than 4.25 200 375

Large corporate term loan
Consider a recent syndicated deal of $115 million Table 1: Pricing grid of PlayCore term loan B
to help fund the acquisition of PlayCore Holdings (LPC Gold Sheets 2000a)
Inc., an unrated holding company with interests
in the sporting and games industries. The Large corporate revolving line
agreement closed on April 14, 2000. Consider a piece of another recent syndication.
The entire $150 million package closed on
The deal includes a $30 million revolver, a March 29, 2000; final maturity is March 29,
$25 million term loan A and a $60 million term 2003. It provides working capital for Rollins
loan B. Credit is secured by a borrowing base Truck Leasing, which is a BBB+ rated company
composed of 85% of eligible accounts receivable, in the truck rental and leasing business.
60% of eligible inventories, plus $3,000 monthly
from November through March. Covenants The deal includes two $75 million revolvers, one
require, among other things, hedging of some with a 364-day term and the other with a three-
interest rate risk, maintenance of minimum year term. Credit is secured by 90% of the net
fixed-charge coverage ratios, limitations on equipment value of all motor vehicle equipment.
dividends, and use of excess cash flow, debt or Covenants include a maximum ratio of funded
equity issuance, or insurance proceeds to retire debt to adjusted tangible net worth and material
outstanding credit under this agreement. Pricing restrictions on dividends. Pricing is tied to the
is tied to the ratio of funded debt to EBITDA company’s senior debt rating. In default, pricing
(earnings before interest, taxes, depreciation and steps up by 200bps or to PRIME + 200bps,
amortization). In default, pricing increases by 200 whichever is greater. The agreement includes a
basis points (bps). The contract allows letter of credit (LC) option. The contract allows
prepayment without penalty at any repricing prepayment without penalty at any repricing
date. date.

We describe the term-loan B component, which We describe the three-year facility. The
is marketed to loan funds. The final maturity of commitment is a bullet bond that expires in its
the loan is July 1, 2006—87 months after the entirety at term. Through September 30, 2000,
April 14, 2000 closing. The 20 quarterly this loan has a price of Libor + 75bps, a
payments of $150,000, starting on October 1, commitment fee (CFCF) of 17.5bps annually, and
2000, are followed by eight quarterly payments of a letter of credit fee (CFLC)of 12.5bps at issuance
$7,125. The loan amortizes over several quarters. plus 75bps annually. Thereafter, beginning on
Initially, at contract closing, this facility is priced the date set by the contract, the grid, summarized
at PRIME + 225bps or LIBOR + 400bps. in Table 2, sets pricing on the basis of the
Thereafter, the pricing grid, summarized in company’s most recent senior unsecured debt
Table 1, determines pricing on the basis of the rating established by Standard and Poor’s (S&P).
company’s ratio of indebtedness to cash flow as Thus, for example, if the company is downgraded
shown in the most recent financial statement. to BBB, the loan moves to Libor + 95bps, a
The current pricing corresponds to a ratio commitment fee of 20bps annually, and a letter
between 4.25 and 4.75, as shown in the second of credit fee of 12.5bps annually, as given in the
row of Table 1. third row of Table 2.

Credit risk valuation framework

Commitment Letter of
Senior rating Prime + LIBOR +
Level fee, CF credit, LC
(bps) (bps)
(bps) (bps)

1 A– or better 0 60 15.0 12.5 + 60

2 [BBB+, A–) 0 75 17.5 12.5 + 75

3 [BBB, BBB+) 0 95 20.0 12.5 + 95

4 worse than BBB 0 115 25.0 12.5 + 115

Table 2: Pricing grid of Rollins’ 36-month revolver (LPC Gold Sheets 2000b)
Middle-market revolving line times. The loan matures 12 months after closing.
Relatively few of the larger middle-market loans The commitment amortization is a bullet bond.
involve syndicates. As is typical of middle-market
loans today, the term is shorter and the structure Credit-default swap
simpler than most large corporate instruments. Consider an agreement providing protection
However, middle-market loans are becoming against default by a Latin American country.
more complex, and some of the larger ones now Under the terms of the five-year contract, the
include three- to seven-year terms, commitment protection buyer owes a fee of 250bps per annum
fees and pricing grids. payable quarterly, in advance, on a notional
principal of $25 million. The protection seller
To illustrate a typical middle-market loan, we
owes nothing unless the country defaults, with
consider a bilateral deal involving one bank but,
default defined by standard documentation.
for confidentiality, change the borrower’s name
Broadly, default occurs if the Latin American
and some of the less important details of the
country misses a senior debt payment or offers a
agreement. This one-year $8.5 million revolving
distressed exchange of assets, or if the market
line supports the working capital needs of NE
value of the underlying asset identified in the
Timber, which is in the logging business.
contract falls by more than a specified amount.
According to the bank’s internal credit rating
system, NE has an S&P-equivalent rating of B. In case of default, the protection seller pays par
for $25 million at face value of the underlying
A borrowing base composed of cash plus 80% of
USD denominated asset, if available, to the
zero- to 90-day receivables, plus 60% of
protection buyer. Alternatively, if the underlying
inventory, plus 40% of raw timber secures credit
asset is unavailable, a fair net cash settlement is
under the agreement. The contract includes the
paid as determined by the calculation agent
standard covenant package, which limits
identified in the contract. The contract
dividends, requires maintenance of a minimum
terminates within a specified short period
ratio of operating cash flow to debt, and
following default, and the protection buyer has
prescribes that any new debt be used first to retire
the right to cancel the agreement at any time.
credit under this agreement. Pricing is at
PRIME + 250, with no fee on unused amounts,
Cash flow timing and components
as illustrated in Table 3.
As illustrated above, the embedded options and
other features characteristic of most credit
Price level Prime + (bps) agreements cause the associated cash flows to
1 250 vary over time and with changes in the state of
the world necessitating a cash flow modelling
approach that accounts for state dependency.
Table 3: Pricing grid of NE’s line of credit
We start by describing the calculation of cash
Prepayment involves no penalty at repricing flows at a given state and time, then discuss the
dates, and a 2% hedge-breakage fee at other modelling of credit-line usage and prepayment

Enterprise credit risk using Mark-to-Future

behavior. These features substantially affect the where CFB denotes cash flow at the beginning of
cash flows and the value of credit contracts at the period; CFE is the cash flow at the end of the
each state and time. period; AC is the commitment amount (which,
We assume a series of discrete time steps though, for a bond, equals the principal outstanding);
for ease of exposition, we focus on a single time CFPP is a prepayment penalty; CFI is the cash
step. All the contingent cash flows whose interest payment; CFP is the principal repayment
contractual values depend on the state at the owed and L is the loss severity rate.
beginning of the time step are modelled.
Equations 1 and 2 show that if the borrower
However, payments may occur either at the
prepays, the holder of the security immediately
beginning or the end of the time step.
receives the outstanding principal plus any
The cash flows realized depend on certain applicable prepayment fee. Otherwise, the cash
contingencies: flow received at the end of the period depends on
whether the borrower defaults during the time
• The payments at the end of the period vary step. If the borrower does not default before
depending on whether the borrower defaults interest and principal come due, the holder of the
during the time step. security receives the amounts owed in full at the
end of the period over which those charges
• The payments both at the beginning and end
accrue. Alternatively, if the borrower defaults,
of the period vary depending on whether the
the holder of the security receives only a portion
borrower chooses to prepay.
(1 – L) of the interest and principal owed. The
Since the main objective is valuation, formulae timing of these cash-flow components is
are developed to express all these cash flows illustrated in Figure 1.
aggregated on a discounted basis at the beginning
of the period. The cash flows for a simple bond
and a default swap are described first, and then Time step
the more involved case of a complex credit
B=t E=t+1
Cash flows in Cash flows in
Consider the simplest case of a bond. At each advance arrears
state and time step, some of the cash flows occur If borrower prepays If borrower prepays
at the beginning of the period (in advance) and Principal 0
some occur at the end (in arrears). outstanding (AC)
Prepayment fee
The bond’s cash flows are expressed as (CFPP)

Otherwise Otherwise
CF B = Interest (CFI) Interest (CFI)
ì Principal Principal
ï AC + CF
PP if prepayment occurs amortization amortization
ï 0 otherwise (CFP) (CFP)

CF E = Figure 1: Usual timing of cash flow

components for a bond
ì 0 if prepayment occurs
ï This method of representing default proceeds is
ï CF +CF if no prepayment and
ï I P
no default occurs (2)
called the recovery of par or legal claims
ï ( 1 – L ) ( CF + AC ) if no prepayment and
approach (see, for example, Duffie and
ï I
ï default occurs Singleton 1999; Jarrow and Turnbull 2000).
î There are other conventional ways of modelling

Credit risk valuation framework

default losses. In the recovery of treasury Equation 4 applies also to the risk-taking side of a
approach, losses (or recoveries) are expressed as total return swap with the bond as the
a fraction of the value of a risk-free bond (Jarrow underlying.
and Turnbull 1995). In the recovery of market
In the next two examples, we simplify the
value approach, losses are expressed as a fraction
presentation by focusing only on expected
of the value of the instrument just prior to
discounted cash flows. In practice, all the
default (Duffie and Singleton 1999). The
conditional cash flows must be captured, without
remainder of this paper focuses on the legal
claims approach.
Credit-default swap
For valuation, the cash flows at the beginning
The one-period expected discounted cash flow of
and end of the time step in Equations 1 and 2
a credit-default swap is given by
can be combined on a discounted basis, using the
discount rate known in the state at the beginning
of the time step. The discounted cash flows at the ECF = CF PP ⋅ P P
–1 (5)
beginning of the period are then given by + ( CFDS – CF C – ( 1 + R ) PD ⋅ L ⋅ AC )
× ( 1 – PP )

ì Equation 5 can be understood as follows. A
ï AC + C F PP if prepayment occurs
ï prepayment in this credit-default swap means
ï –1 (3)
í ( 1 + R ) ( CFI + CFP ) if no prepayment and no default occurs that the protection buyer cancels the agreement.
ï –1 This event has a probability, P P . In this case, the
ï ( 1 + R ) ( 1 – L ) ( CF I + AC ) if no prepayment and default occurs
seller might receive a cancellation fee (CFPP).
Otherwise, if the contract continues, the buyer
Here, DCF denotes discounted cash flow and R
pays a premium at the start of the period (CFDS)
the applicable one-period (simple) discount rate,
conditional on the state of the world at the and the seller incurs servicing and monitoring
beginning of the time step. costs (CFC). If default occurs, the protection
seller pays compensation (L ⋅ AC) to the buyer at
Assume that, at the beginning of the time step, the end of the period, where AC is the
default has not occurred and that, based on the committed amount.
time and state of the world, we know
Bank-credit facility
• the risk-neutral prepayment probability, PP Bank-credit facilities sometimes allow the
borrower to obtain credit by choosing from
• the risk-neutral probability that default among a set instrument types. In the most
occurs during the time step, conditional on general case, the borrower obtains credit by
no prior default and all prior information, PD. means of:
• a term loan
Then, the risk-neutral expected value of cash
flows discounted over the time step can be • a funded revolving line
obtained by taking the expectation in Equation 3 • a letter of credit
with respect to the (one-period) risk-neutral
default and prepayment probabilities to derive • banker’s acceptance.
the expected discounted cash flow of a bond at Although it is rare for a single credit agreement
the beginning of the period: to grant the borrower the option of choosing
from among all of these instruments, the
ECF = ( AC + CFPP ) ⋅ PP simultaneous use of all of these instruments leads
–1 (4) to payments of interest and several different
+ [(1 + R ) ( ( 1 – P D ) ( CF I + CF P )
kinds of fees. The complexity of the resulting
+ P D ⋅ ( 1 – L ) ( CFIS + AC ) ) ] ⋅ ( 1 – PP )
cash flows illustrates the required flexibility of

Enterprise credit risk using Mark-to-Future

the model. The timing of cash flow components

for a bank-credit facility is illustrated in Figure 2.

Utilization rate (%)

Time step

B=t E=t+1

Cash flows in Cash flows in B=t–1 E=t

advance arrears B=t E=t+1

Upfront fee
(only if t = 0) (CFUF) Figure 3: Modelling credit-line usage
Tables A1 to A5, in Appendix 2, summarize the
If borrower prepays If borrower prepays
relevant balances, bank cash flows, pricing rates,
Term loan 0
Outstanding (OSTL) cost rates and utilization rates for a bank-credit
Prepayment fee facility.
The cash flows from a bank-credit facility include
Otherwise Otherwise the following items paid at the beginning of the
Facility fee (CFFF) Interest (CFI) period:
LC fee (CFLC) Term loan
BA fee (CFBA) Amortization (CFP) • For a new facility (t = 0), the borrower may
(Operating costs) Revolver draw owe an “upfront” fee, CFUF; at other times,
(–CFC) Repay (OSRV) CFUF = 0.
(Revolver draw) Commitment fee
(–OSRV) (CFCF) • In the case of prepayment, the borrower
Utilization fee returns the outstanding principal, OSTL , and
(CFUT) pays any applicable prepayment penalty,
CFPP. Thus, with probability PP, prepayment
occurs and leads to a total cash flow of
Figure 2: Usual timing of cash flow components
for a bank-credit facility CF UF + OS TL + CF PP

In bank-credit agreements other than straight, Note that, under this end-of-period revolver
repayment convention, only the outstanding
term loan facilities, the borrower has discretion,
term loan amount is repaid at the beginning of
within limits, in choosing when to obtain credit,
the time step if prepayment occurs (see Figure 3).
when to repay it and in what amounts. For If no revolver draw occurs at the beginning of a
modelling purposes, we assume that the borrower period in which the borrower prepays, the
chooses the desired draw on a credit line at the repayment of the term loan reduces the
beginning of each period and repays or cancels in outstanding balance to zero.
full at the end of the period (as illustrated in
Figure 3). This approach, in effect, treats the • If the credit facility continues, the borrower
owes, at the start of the period, any
varying outstanding amounts in a credit line as a
applicable facility fees, CFFF, letters of credit
time series of differently sized one-period term
loans. While this payment-and-draw pattern may fees, CFLC, and banker’s acceptance fees,
not mirror the actual sequence of transactions, CFBA. The borrower’s draw of funds on a
the state-contingent draws at the beginning of credit line, OSRV, and the lender’s expenses,
each time step offset any overstatement of CFC, occur in advance. These items create
repayment at the end of the preceding time step. cash outflows, which appear as negative

Credit risk valuation framework

entries. Thus, with probability 1 – P P , there ( AC ⋅ REU + AC ⋅ ( 1 – REU ) ⋅ LEQAC )

is a total beginning-of-period cash flow of less the funded outstanding balance at the
CF – CF + CF + CF – OS – CF
beginning of the period,
If the credit facility continues, several additional
cash flows occur in arrears and the amounts This contributes to an additional cash flow loss at
realized depend on whether the borrower the end of the period
L [ AC ( REU + ( 1 – REU ) LEQAC ) – OS – OS ]
• Interest, CFI, commitment fees, CFCF,
utilization fees, CFUT, and principal This expression adjusts for the additional draw on
repayment, CFP, come due at the end of a a credit line that frequently happens as a
borrower goes into default. For time steps as long
period. Also, by modelling convention, the
as one year, this adjustment is needed to
funded revolving amount, OSRV, is paid at
represent accurately the amount that will be
the end of a period. Thus, in the absence of outstanding and thus vulnerable to loss in
default, the total cash flow at the end of the default. For time steps as short as one month or
period is one quarter, the LEQAC adjustment may be
CF + CF + CF + CF + OS inappropriate.
Suppose that, during the year leading up to
• In default, we assume that the borrower pays
default, borrowers make additional draws of
only the portion (1 – L) of those amounts
about 40% of the original commitment less the
owed. The loss-in-event-of-default rate (L)
amount typically drawn; then, for an annual time
reflects the seniority of the obligation,
step, LEQAC = 40%. Assuming the normal
strength of covenant protection, the value
utilization rate REU = 30% (which implies a
and type of any collateral and the protection
normally undrawn fraction of 1 – REU = 70%),
afforded by subordinated debt. Also, in
the expected usage in default is
default, the creditor receives only the portion
0.30 + 0.70 × 0.40 = 0.58. The additional draw
(1 – L) of the principal outstanding. Thus, all
together, the cash flows at the end of the in default is thus 0.58 – OSTL – OSRV .
period if default occurs are
The loan equivalency factor, LEQAC, measures
( 1 – L ) ( CF + CF + CF + CF + OS ) the proportion of normally undrawn balances
that have been drawn and thus are vulnerable to
• For credit lines with commitments available loss in the event of default. Thus, it reflects two
(i.e., when AC > OSTL), the outstanding competing effects:
principal can rise as the borrower goes into
• the deteriorating borrower’s attempt to draw
default. The loan equivalency of the
additional funds to cover an increasing cash-
commitment, LEQAC, and the normal
flow deficiency, and
utilization rate, REU, determine the amount
of this additional draw. Specifically, the • the lender’s attempt to reduce the
funded outstanding amount in default is the commitment available to a deteriorating
sum of the normally drawn amount borrower who predictably violates some loan
( AC × REU ) and the normally undrawn covenants.
amount, weighted by the LEQAC factor Weighting by the appropriate probabilities and
( AC ⋅ ( 1 – REU ) ⋅ LEQAC ) . The discounting the cash flows occurring at the end
additional draw in default is then given by of the period, all of these components are
the expected outstanding amount in default, consolidated to obtain the expected discounted
which is the sum of two terms cash flow of the credit facility:

Enterprise credit risk using Mark-to-Future

ECF = ( CF
+ OS
+ CF
) ⋅ PP Several standard accounting relationships and
other formulae ultimately tie the cash-flow
+ [ ( CFUF + CF FF + CF LC + CFBA – OSRV – CFC )
components previously shown to model inputs
+ ( 1 + R )-1 { ( 1 – PD ) ( CFI + CFCF + CFUT + CFP + OS RV ) that describe the pricing and structure of the
+ PD ( 1 – L ) ( CFI + CFCF + CFUT + OSTL + OSRV ) (6) credit facility, market conditions and borrower
– PD ⋅ L ⋅ ( AC ⋅ ( REU + ( 1 – REU ) ⋅ LEQAC ) –OSTL – OS RV ) } ] behavior. Most of these primary relationships
× ( 1 – PP )
determine cash flows as the product of rates and
balances. For example:
The LEQAC factor controls explicitly the usage
of the credit line in default Equation 6. • The interest payable, CFI, equals the product
Moreover, it also controls the maximum usage of of the contractual interest rate, RI, and the
the credit line in non-default. Thus, it also affects outstanding funded balance, using the proper
several cash flows and outstanding amounts in day count and compounding conventions.
Equation 6, through the credit line usage model.
The LEQAC factor is further explained in the • The interest rate, RI, equals either a specified
next section. Since one expects that the fixed rate or the current value of the relevant
incentive to draw will be highest as the borrower floating rate computed as the sum of a base
goes into default, our assumptions do not allow rate and a spread.
usage in default to rise higher than that in a non-
default situation. • In the case of a choice among varied floating
rates, the option that provides the lowest
Note that LEQAC measures the exposure in rate, or the lowest rate that falls between an
default as a fraction of the original, and not of the interest rate floor and ceiling, determines the
terminal, commitment. Its value can be imputed floating rate.
from market pricing of undrawn commitments or
from past evidence on the usage of normally • The spreads valid at the current time and
undrawn amounts in default. For example, state depend on the pricing grid, if there is
suppose that market credit spreads on undrawn one. Similar considerations arise in
balances average about 25% of those on drawn determining other cash flow components.
balances. This motivates a LEQAC value of 25%.
Alternatively, suppose that past data show that, To conclude this section, note that two different
in default, borrowers end up drawing about 50% assumptions on operating costs may give rise to
of the commitment that was unused early in the different expected cash flows and the value of the
life of the facility before any substantial decline in loan at each state and time. Operating costs can
creditworthiness. This suggests LEQAC = 50%. be seen from the perspectives of the market and
Studies typically estimate LEQAC well below the lender. The costs of efficient credit providers
100% and the Bank for International Settlements can be imputed from market spreads on loans.
capital adequacy guidelines (BIS 1988) prescribes These market-derived costs affect market values,
a value of 50% for undrawn commitments which, in turn, affect prepayment behaviour.
extended for one year or more. Prepayment logically depends on the borrower’s
The concept of a loan equivalency factor is opportunities in the market as compared with the
familiar to practitioners exposed to BIS and given loan. On the other hand, the lender’s costs,
internal capital allocation schemes. An as estimated possibly from activity-based studies,
alternative and more direct approach to using can differ from market-derived costs. In that
LEQAC is to model the credit line that the case, the value of a loan from the viewpoint of
lender predictably achieves as the borrower’s risk the lender differs from its competitive market
rating degrades. This can be seen as a lender’s value. Assessing the difference between these
“option to reduce the line.” Thereafter, the two prices is an important exercise for the lender.
borrower is free to use the whole amount of the We elaborate further on these two perspectives
reduced commitment. when discussing the prepayment modelling.

Credit risk valuation framework

Modelling the embedded options includes the credit state of the obligor as well as
Equations 4 to 6 describe the expected market conditions. The terms that are affected by
discounted cash flows for a bond, a default swap utilization are the cash flows CFLC, CFBA, CFC,
and a general bank-credit facility, at a given CFI, CFCF and CFUT, as well as the outstanding
point in time and state of the world. Embedded amounts OSRV, OSLC and OSBA.
in these formulae are three types of options that
depend on credit events: Default probabilities and credit migration are
captured through the underlying credit model.
With a default option, the borrower may not pay The necessary characteristics of the credit risk
an obligation in full in the event of default. The model are described in the next section. In what
expected cash flows of the bond, credit default follows, we describe the modelling of prepayment
swap and bank-credit facility are affected and line utilization, which occur simultaneously
explicitly by this option through the probability in a comprehensive framework. Hence, many of
of default, PD, in Equations 4 to 6. the same cost considerations apply in both cases.
With a prepayment option, the obligor has the Prepayment
right to prepay commitments or cancel the It seems plausible to assume that the borrower
contract at specified times before maturity. will exercise the option to prepay a loan
Prepayment generally depends on whether it is instrument if the market value of the loan,
cheaper for the obligor to cancel the deal and conditional on it continuing, VNM, rises high
enter into an identical one in the market, netting enough above par to pay for
for cancellation costs and fees. This occurs when
the market conditions (interest rates and • any prepayment penalty, given by a
spreads) move sufficiently in the obligor’s favour prepayment rate times the committed
or if there is a substantial improvement in amount, RPP ⋅ AC
creditworthiness, thus allowing the obligor to
negotiate lower spreads. • refinancing transactions costs of the
borrower, given by fixed and variable costs of
The value of this option depends directly on both searching for and negotiating a new loan,
the market conditions and the creditworthiness FTCPP + MTC PP ⋅ AC
of the obligor. In this sense, the option is
contingent on credit events other than default • origination costs, which are the (fixed and
(credit migrations). The expected cash flows in variable) costs that an efficient lender in the
Equations 4 to 6 are explicitly contingent on primary market incurs in originating a new
prepayment through the probability of facility, FC ORIGM + MC ORIGM ⋅ AC .
prepayment, PP, which, in turn, is dependent on
the credit state of the obligor as well as the level Combining these three items, we obtain the total
of risk-free interest rates and spreads. transaction cost of prepayment (TCPP):

With a credit line utilization option, an obligor TC PP = R PP ⋅ AC + FTCPP + MTCPP ⋅ AC

has the right to choose the usage level of a given
commitment. Of the three examples, only the
bank-credit facility offers this option. It is
We assume that, in a given state of the world, the
generally the case that as an obligor’s
borrower will prepay if, in switching to a new
creditworthiness diminishes, the draw on the
loan with a competitive value of par in the
credit line increases. Therefore, as with the
secondary market, the savings relative to the
prepayment option, the credit line utilization
existing above-par loan more than cover the
contains an embedded option on credit events
transactions cost. Thus, the probability of
other than default, such as credit downgrades.
prepayment in a state of the world, PP, can
This option makes several terms in Equation 6 assume only the values of zero or one and simply
contingent on the state of the world, which now becomes an index of the prepayment event

Enterprise credit risk using Mark-to-Future

ì 1 if VNM – OS TL > TC PP the borrower, assuming compliance with the loan

P = í covenants. The compliant borrower may use this
î0 otherwise
amount in varying degrees from 0% to 100%.
Although one could more generally model PP as The usage model determines two components:
a continuous monotonic function of the
• the overall usage, RUACA, of the available
predicted prepayment savings
( VNM – OS TL – TC PP ) , in practice, it is difficult
to obtain data to calibrate this function to actual • the relative usage of the different instrument
borrower behaviour. options: the funded revolver, the letter of
credit and the banker’s acceptance.
As an example, consider the workings of the
prepayment model in the case of a $10 million The overall and relative utilization rates
facility. Suppose that as a result of an upgrade in determine, in Equation 6, cash flows CF LC ,
creditworthiness, the facility’s NPV in the CFBA , CFC , CFI , CFCF and CF UT , as well as
market, conditional on no prepayment, rises to the outstanding amounts OSRV , OSLC and
$150,000. Assume that, in refinancing the loan,
an efficient lender will incur origination costs of OSBA . The cash flows are obtained by
$40,000 and that the borrower will incur search multiplying contractual pricing rates by the
and negotiation costs of $15,000. Assume, corresponding drawn (outstanding) or undrawn
further, that there is no prepayment fee. The (commitment less outstanding) balances. The
total transaction cost of $55,000 falls short of the outstanding amounts also influence operating
$150,000 gross savings that the borrower can costs and exposure.
realize from refinancing. The model will predict
We now describe the models for the overall and
relative usage rates.
To implement this approach and ultimately
determine the credit facility’s value to a Overall usage rate, RUACA
particular lender, both the lender’s and the The borrower’s usage of the available
market’s costs of originating and of servicing commitment amount is modelled as a function of
loans must be estimated. By “market” costs we the net credit line cost. This can best be
mean those of competitive providers of credit. explained in several steps.
Borrower costs of transacting a new loan must We start by defining the available commitment.
also be determined. These estimates come from Term loans basically involve a known schedule of
varied sources as described further in the data outstanding amounts; hence, they are
calibration section. deterministic. All of the other bank loan types—
Credit line utilization
funded revolvers, letters of credit, bankers’
In bank-credit agreements other than straight, acceptances—involve outstanding balances that
term-loan facilities, the borrower has the option may fluctuate randomly. Thus, to determine the
to choose the usage of the line. Obviously, the range of possible random variation in credit
line utilization is realized only in the event that outstanding, we need to identify the commitment
the borrower does not prepay the facility. The amount in excess of that set aside for a term loan.
usage of a line influences both the payments that The available commitment, ACA, given by the
the borrower owes to the creditor as well as the total commitment, AC, less any term-loan
amount of exposure that the creditor bears. In outstanding amount, OSTL, can also be expressed
Equation 6, the usage of the line affects several as a proportion of the total commitment
cash flows and outstanding amounts as described
below. ACA = AC – OS TL = AC ⋅ ( 1 – REUTL ) (7)

The amount outstanding as a term loan, OSTL, is where REUTL denotes the portion of the facility
fixed by the loan contract. Any remaining devoted to a term loan. This is an attribute of the
commitment above that amount is available to loan contract. In many cases, REUTL = 0%—a

Credit risk valuation framework

pure revolving line—or REUTL = 100%—a available evidence generally suggests a less
straight, term loan. Equation 7 also describes the extreme reaction, where usage rises rather
case of a multi-instrument facility that includes a continuously as the credit rating degrades. Thus,
term loan as a component. a plausible model expresses usage as a logistic
function of net credit-line cost, N, as shown in
Then, the amount of available commitment that
Figure 4.
is outstanding, OSACA, is given by the product
of the available commitment and its usage rate,

Usage rates vary widely depending on the

purpose of a facility. A backup line generally has
low usage rates, while an operating line has
relatively high rates. The normal usage pattern is
assumed to be provided by the user who knows
the facility’s purpose.
We assume that the borrower tries to minimize
the costs of required credit. This suggests that
the usage rate, RUACA, rises above its
anticipated value if the marginal cost of drawing
credit becomes cheap, and falls if the marginal Figure 4: Capped logistic usage function
cost becomes expensive. “Cheap” and
“expensive” mean “low” and “high,” respectively, When the net cost is at zero, or at some other
relative to the market par cost of obtaining near par value established by assumption, the
credit. If the cost of obtaining additional credit usage rate equals the anticipated value for the
under the existing line rises far above the market facility; that is, RUACA=REU (see Equation 6).
par cost, then the borrower should be able to find As shown in Figure 4, when the net cost falls
cheaper credit elsewhere. The borrower would sufficiently below par, the logistic function is
logically curtail usage of the credit line. If the capped to reach a maximum, through the use of
cost under the existing line falls far below the the loan equivalency of undrawn commitments
market par cost, the borrower would tend to (LEQAC). Usage reaches a minimum when the
draw on the line and reduce the use of net cost rises well above par. The parameters of
alternative credit. the logistic curve allow for calibration to the
Let CC represent the marginal cost of credit limited information on utilization patterns.
under the existing credit line and let MC denote
the market cost, with both expressed in basis Recall that the LEQAC rate controls both the
points. We define the net credit-line cost, N as maximum usage in non-default and the usage in
default. It represents, roughly, the effect of lender
N = CC – MC options to reduce a credit line as a borrower with
Appendix 3 explains how the marginal cost of deteriorating creditworthiness violates
credit, CC, and the market cost of credit, MC, covenants.
can be computed in a given state of the world
If the contractual pricing of the facility does not
and time step.
itself depend on usage, then we obtain directly a
As a practical matter, major changes in the net single value for the net cost of a draw, N. The
cost of drawing credit mostly reflect shifts in logistic function capped by the LEQAC factor in
creditworthiness. One might expect the borrower Figure 4 determines directly the usage, RUACA.
to draw the maximum amount possible whenever Mathematically, we express this as
the net cost falls below zero and draw nothing
whenever it rises above zero. However, the RUACA = U ( N )

Enterprise credit risk using Mark-to-Future

where U(N) denotes the usage function in

Figure 4.

However, some credit instruments include

utilization fee schedules that assess incremental
charges on usage in excess of specified
thresholds. For example, a utilization fee
schedule could specify no fee on utilization less
than 33%, a 5bps surcharge on usage above 33%
up to 50%, and an additional 5bps (for a total of
10bps) on incremental usage above 50%. In this
case, a numerical algorithm must be used to solve
simultaneously for the net cost, N, and the usage Figure 5: Example of relative usage schedule for
rate, RUACA. instrument option

Credit risk valuation framework

Relative usage rates of different instruments
As illustrated above, most credit agreements
The usage model also deals with a general, multi- include key embedded options, notably the
option facility in which the borrower has the borrower’s option to prepay or cancel a contract,
right to draw credit as a funded balance, a letter and to draw on a credit line. As a result of these
of credit or a banker’s acceptance. To model the options, the cash flows from credit facilities vary
relative usage of these different instrument with time, borrower creditworthiness (e.g., risk
options, one starts by determining which, if any, rating), interest rates and credit spreads. In
particular, a decrease in interest rates or credit
offers the cheapest cost of drawing credit. Then,
spreads or an improvement in borrower risk
relative to its anticipated value, the usage of any rating may trigger prepayment, drastically
less economical instrument drops as its cost changing cash flows. Furthermore, more complex
spread relative to the minimum cost option credit facilities also include additional features
grows. Figure 5 gives an example of the relative such as pricing grids, graduated utilization fees
usage function. The relative usage for a given and amortization schedules that amplify the state
instrument is given as a decreasing function of and time dependency of cash flows.
the spread gap to the minimum cost option. In essence, we require an underlying credit risk
model that describes each state of the world by
This model of line usage accounts for the price of
credit in contrast with approaches that tie usage • the creditworthiness of the obligor (perhaps
only to the borrower’s credit grade as given by a discrete set of credit ratings and
(CreditMetrics 1997). Such approaches imply default probabilities)
that usage is the same at a risk grade regardless of • the term structure of default-free interest
the cost of obtaining credit and, hence, may not rates
be very realistic. • the term structures of credit spreads for non-
defaulted securities.
Information on relative usage of alternative
In principle, each of these sets of variables can
instrument options is very limited. The basic
vary stochastically through time. Intuitively, one
economic incentives faced by a borrower
would expect that at least three factors are
motivate the approach here. Parameters that required to capture this stochasticity in a
limit the intensity of this economic incentive reasonable way (e.g., a credit rating index, the
effect can be established if other considerations risk-free short rate or forward rate and a systemic
determine a borrower’s relative usage of the factor affecting credit spreads). The choice of the
different instrument options. model, however, depends on trade-offs between

Credit risk valuation framework

the generality, complexity, speed, data The potentially high dimensionality of rating-
requirements and accuracy of the model. For based models presents various theoretical and
example, if one is interested in valuing floating practical challenges. For example, in the most
rate instruments, then an assumption of general case, a rating system with n credit states
deterministic risk-free interest rates and spreads implies the need to calibrate on the order of n2
may be appropriate and a one-factor model may parameters (rating transitions) per time step.
be used. However, for fixed-rate instruments, it is Clearly, some reasonable structure to reduce the
important to have a stochastic model describing dimensionality of the problem must be added.
the evolution of risk-free interest rates. This can The JLT model presents one such approach and
be done generally through a one-factor term- Lando (1998) discusses more generally a number
structure model. Although it may be tempting to of additional practical approaches.
use multi-factor models that better describe the
evolution of the term structure, this may lead to In general (assuming complete markets), no-
an overall credit valuation model of arbitrage models require only pricing data for
dimensionality that is too high to be practical. calibration. Rating-based models, in contrast,
start by using real transition matrices (like those
In what follows, some of the issues that influence provided by S&P’s and Moody’s) to describe the
the choice of the underlying credit risk model, high-dimensional, discrete-transition probability
the data required and the basic structure of the space. One usually assumes that the evolution of
underlying pricing framework are highlighted. the obligor’s creditworthiness follows a time-
homogeneous Markov process (in the real
Choice of underlying credit risk model
measure). A low-dimensional process is then
Credit risk pricing models are broadly classified in
applied to modify the transition matrix in order
the literature into two main categories: the so-
to fit to the observed term structure of market
called structural approach and the reduced-form,
spreads. This yields the so-called risk-neutral
or intensity-based, approach. See Das (1998),
measure. Typically, this calibration step may
Duffie and Lando (1997) and Jarrow and
convert the process into a time-inhomogeneous
Turnbull (2000) for comprehensive descriptions
Markov process (under the risk-neutral
of the two approaches. (The reader is also
referred to Aziz 1999a, 1999b, 2000) for some
simple practical explanations of the general One can use the JLT or Lando low-dimensional
principles underlying these models.) Appendix 4 process transformations to fit the observed credit
provides a brief review of these credit risk spreads. However, in practice, this choice is not
approaches. obvious. For example, since the JLT approach
involves a proportional scaling of the transitions,
In general, cash flows for loans vary with changes
it sometimes leads to numerical problems when
in the creditworthiness of a non-defaulting
applied in practice. Lando’s approach using
borrower, that is, movements between the
eigenvalue decomposition can also lead to
various ratings grades short of default. Therefore,
practical numerical problems. Moreover, in both
models that distinguish among many possible
cases, the transformations are chosen for
credit states, not just default and non-default, are
mathematical tractability and are not derived
required. Multi-credit state (rating-based)
from underlying financial principles.
models seem particularly suitable for this problem
(e.g., Jarrow, Lando and Turnbull 1997 (JLT); Note that by defining credit states as arising from
Lando 1998). In terms of applications specific to an underlying process of the value of the firm,
the loan market, rating-based models were first structural models can also be useful for this type
used in Ginzberg et al. (1994). Aguais et of problem. However, these models may be
al. (1998) and Aguais and Santomero (1998) difficult to fit to market data (particularly short-
also describe valuation applications that use a term spreads) and their use, in practice, may
multi-state model for evaluating the embedded require some extra level of sophistication for
options and other structural features found in modelling cash flows such as those found in loan
loan instruments. instruments. A mixed model that combines

Enterprise credit risk using Mark-to-Future

functional parts of reduced form and structural Calibration data for the credit model and the cost
models provides a sensible alternative. models
The data required for calibrating the underlying
The mixed approach assumes that there is an credit risk model depends on its level of
(unobserved, perhaps) underlying structural sophistication. For a model with deterministic
process, referred to as the creditworthiness index spreads (two-factor model), the data for
(CWI), determining a firm’s credit state. This calibration include
approach was first advanced in the CreditMetrics
methodology (CreditMetrics 1997). As in the • default-free term structure of interest rates
Merton model, default occurs when the CWI
falls below a given threshold or default boundary. • defaultable term structure of interest rates
Also, one may define multiple thresholds that (spreads) for each rating class derived from a
determine various credit states. combination of bond and loan data
• current transition matrix (as estimated, for
In the CreditMetrics approach, the default and
example, from historical data as with ratings
migration thresholds are fit directly to match
agencies or from a market-based model such
observed (one-year) rating migrations and
as that of KMV or Moody’s)
default probabilities. Assuming that the
underlying index is Gaussian, simple closed-form • recovery rates for each seniority and
solutions can be obtained for one-period collateral class as well as by advance rate.
problems. As shown in Gordy (2000), Koyluoglu
and Hickman (1998), and Belkin et al. To include further stochastic spreads in the
(1998a,1998b), the model leads naturally to the model, one also requires
modelling of stochastic default probabilities and • implied spread volatilities from traded
transitions as a function of systemic risk factors. instruments or, if these are not available, a
The CreditMetrics methodology solves the time series of historical spreads or default/
problem only for a single step. Multi-step versions transition data.
of the methodology are presented in Iscoe et al.
(1999) and Li (2000). To obtain a correlated model of default-free and
defaultable rates, one requires
In summary, one may obtain a sensible
underlying credit risk model for elaborating on • time series of default-free interest rates and
the three factors outlined above: spreads or, alternatively, observed default
probabilities, to estimate correlations.
• Factor 1: borrower creditworthiness, as
designated by a set of discrete credit ratings Ideally, we calibrate the model to prices of liquid,
frequently traded credit instruments representing
• Factor 2: default-free short rate or the economic regions, sectors and risk grades and
continuous forward rate, as determined by a terms needed for a comprehensive description of
Heath-Jarrow-Morton model or discrete credit risk. It is important to note that one must
forward rate, driven by a Brace-Gatarek- extract option-adjusted spreads from the raw
Musiela model (At a higher computational pricing information, to obtain the zero spreads
cost, one may choose a higher dimensional used to calibrate the credit model. Recovery rates
model of the default-free term structure.) used in this calibration are usually drawn from
• Factor 3: systemic factor describing bond and loan recovery studies (see, for example,
stochastic credit spreads, from a stochastic Brand and Bahar 1998 and Eales and Bosworth
intensity model or as the systemic 1998). Finally, under the best circumstances,
component of a structural creditworthiness time series of credit prices to estimate spread are
index. gathered.

Credit risk valuation framework

Pricing data from both the bond and loan of 60bps for the total of borrower
markets are used. Unlike bond spreads, loan transactions costs and lender origination
spreads comprise an implicit cost component costs might seem reasonable. Then, given a
paid out of designated margins. As mentioned value of 35bps for competitive origination
earlier, to determine the credit facility’s value to costs (in Equation 9), the borrower cost of
a particular lender, one requires a model for both searching for and negotiating a new loan is
the lender’s and the market’s cost of originating 25bps.
and servicing loans. “Market” costs are those of
competitive providers of credit. One also needs In most cases, these factors can be estimated only
to estimate borrower costs of transacting a new roughly, given the state of the current data. In
loan. The estimates of lender, market and particular, due to non-reporting of some upfront
borrower costs come from varied sources. payments to lead arrangers, the available data
For a particular lender, the cost information could well understate lender origination costs.
could derive from proprietary studies of credit All such estimates of operating costs and of pure
activities at the institution. These costs might credit spreads (excluding costs) need, together,
differ from market implied costs. While to reconcile with market pricing.
sometimes difficult in practice, market costs can
be imputed from observed prices of loans and The loan market data cover mostly large
other instruments such as bonds. We illustrate syndications, with occasional sketchy reports on
this process with several examples: general trends in the US middle market. Data on
investment-grade, syndicated loans come mostly
• Suppose, in the secondary market, high-
grade term loans have option-adjusted from the primary market. Only speculative-grade
spreads that exceed those of comparable loans trade enough for compilation of reasonably
bonds by 45bps. That value might be taken reliable secondary-market prices. Loan pricing
as an estimate of the cost of servicing and vendors currently provide benchmark prices by
monitoring those loans. In loans, the spreads credit grade for only two broad maturity bands—
pay for those costs, whereas, in bonds, they 364 days and multi-year (four to six years on
do not. Alternatively, if the servicing average). One vendor provides such pricing
tranches on collateralized loan agreements information for several industry groups. As
offer spreads of about 40bps, that might be suggested earlier, extracting the zero-rates term-
taken as a general estimate of servicing loans. structure (plain vanilla structure) from the raw
• With regard to origination costs, suppose prices may not be easy due to the complex
that, following payment of reported upfront structure and embedded optionality in loans.
fees averaging 40bps, term loans in the This process of adjustment depends on the model
secondary market trade at an average of itself and can be complex.
99.8% of par. We might conclude, therefore,
that it costs lenders about 20bps to originate Credit risk valuation architecture
loans. Assuming that loans typically originate
We now describe the overall architecture
at par and solving for origination costs
required to support the pricing and structuring of
100% + FCORIG – CF UF × 0.4% = 99.8% (9) loan instruments.

• Suppose that the combined selling and From a business perspective, the architecture
underwriting expense of bond issuance are must support the primary requirements of valuing
reported to average 40bps. This can be used each individual transaction at origination and
as an approximation of origination costs for MtM for an entire portfolio of credit instruments.
syndicated loans. The support of loan valuation over a set of future
• If almost no loan in the secondary market scenarios (Dembo et al. 2000) is also required for
trades higher than 100.6% of par, an estimate advanced portfolio credit risk solutions.

Enterprise credit risk using Mark-to-Future

Credit Risk Calibration

Market Prices (for bonds and loans) Current Credit Data Spread Volatility
-default-free term structures -transition matrices -implied from option prices
-defaultable term structures (historical or market-based) -historical spread and
(spreads/rating class/sector) -recovery rates/seniority class default information

Calibration of Credit Risk Model

(state space risk-neutral probabilities)

Credit State Space (Path) Generation Outputs

Instrument (lattice or Monte Carlo)
Valuation -NPV
Definitions Algorithms -price
Cash-Flow Generators -par spreads
-loan dates
-cash flows
-option values
-risk rating
Grid Cost Usage Prepayment -duration
-collateral type
Model Model Model Model -hedge ratios
-grid pricing
-prepayment fees
Other Calibration Data
Cost Data Usage Data Prepayment Data

Figure 6: Overall architecture

In terms of technology support for these two • Usage, prepayment and cost calibration
business objectives, valuation at origination data: this includes data to support the
requires pricing and structuring decision support calibration of behavioural options
for a large number of users in the front office, components such as line utilization and
while MtM analysis typically requires middle- prepayment. In addition, operating costs,
office, batch-mode analysis for an entire loan which are part of the overall loan spread as
portfolio. Recent advances in technology, such as highlighted, are determined by market-based
web-based tools, provide a platform for the information or a bank’s own internal cost
deployment of this type of valuation framework, assessments.
by placing decentralized valuation analysis much • Core analytics: the core analytics include
closer to the customer, while providing modules that determine option-exercise
centralized management and control of complex behavior and the generation of state-
analytics, key calibration parameters and credit contingent cash flows. These are combined
data. with the valuation algorithm, using either
In Figure 6 we highlight the overall architecture Monte Carlo or lattice-based methods.
needed to support implementation of this credit • Credit instrument definitions: the specific
valuation approach, including five key terms and conditions of each credit
components: instrument are inputs; the valuation outputs
• Credit risk calibration data: this includes describe the loan’s risk-adjusted
market data for bonds and loans (spreads), characteristics.
current credit data (default probabilities, • Output reports: these include prices, par
transition matrices and recovery rates) and spreads, cash flows, sensitivities, “what if”
spread volatility data. analyses and so on.

Credit risk valuation framework

The pricing algorithm can be based on either a The proposed multi-state, ratings-based credit
lattice-based or Monte Carlo-based approach. modelling approach with three factors captures
When working with up to three factors, lattice- the main characteristics of loans. By
based valuation methods are probably the most incorporating a stochastic interest rate factor, the
appropriate. In this case, a state-space lattice model also values both floating-rate and fixed-
provides the framework that combines the cash- rate credit instruments. Stochastic credit spreads
flow generating modules, which include the can be supported by incorporating a systemic risk
behavioral option-exercise logic, with the factor, which also captures the business cycle.
backward recursion algorithm that determines This point is key since a prepayment-option
expected values. In particular, given that exercise is driven by both movements between
prepayment exercises depend on the actual value credit states and changes in the level of the term
of the contract to the holder at a given state of structure of credit risk.
the world and time, lattices provide a natural way
As financial institutions progress toward applying
to compute exercise boundaries (as is common,
MtM valuation to loans to support trading and
for example, with American options).
credit risk transfer, this type of framework
When the dimensionality of the model is higher, represents a key step forward. For those
Monte Carlo methods are generally necessary to institutions that understand the arbitrage
solve for the loan prices. These methods further opportunities available in the loan market, the
allow for the handling of more complex path- business benefits will be substantial.
dependent instruments, as well. However, Monte Implementation of valuation methods that
Carlo pricing usually has a high computational incorporate detailed, state-contingent loan
cost. Furthermore, as with American options, the structures will also support improved estimates of
practical implementation of the prepayment logic portfolio credit Value-at-Risk.
is more difficult in this case.
Concluding remarks Aguais, S., L. Forest, S. Krishnamorthy and T.
We present a general option-valuation Mueller, 1998, “Creating value from both loan
framework for loans. While the focus is primarily structure and price,” Commercial Lending
on large, corporate and middle-market loans, the Review, 13(2): 13–24.
approach is applicable more generally to bonds
Aguais, S. and T. Santomero, 1998,
and credit derivatives. This framework provides
“Incorporating new fixed income approaches
key valuation information during loan
into commercial loan valuation,” Journal of
origination, and it supports MtM analysis for the
Lending and Credit Risk Management, 80(6):
entire loan portfolio, portfolio credit risk and
asset and liability management. We emphasize
the modelling of key product-specific features of Asarnow, E., 1994, “Measuring the hidden risks
loans and not the simple application of a specific in corporate loans,” Commercial Lending
type of pricing model to the problem. We Review, 10(1): 24–33.
describe the main structures found in commercial
Aziz, A., 1999a, “Algo Academy Notes,” Algo
loans, such as utilization of credit lines and
Research Quarterly, 2(1): 65–72.
options to prepay, as well as outline the practical
assumptions required to model the state- Aziz, A., 1999b, “Algo Academy Notes,” Algo
contingent cash flows resulting from these Research Quarterly, 2(3): 65–71.
structures. The credit risk model characteristics
Aziz, A., 2000, “Algo Academy Notes,” Algo
necessary to capture the main features of the
Research Quarterly, 3(1): 75–85.
problem are also defined. Finally, we discuss
briefly the families of credit models that may be Bank for International Settlements, 1999, “A
appropriate for pricing, the data required for their new capital adequacy framework,”
estimation and reasonable criteria for choosing Consultative Paper, Basle Committee on
the sophistication of the model. Banking supervision, April.

Enterprise credit risk using Mark-to-Future

Bank for International Settlements, 1988, Ginzburg, A., J. Maloney, and R. Wilner, 1994,
International Convergence of Capital “Debt rating migration and the valuation of
Measurements and Capital Standards, Basle commercial loans,” Citibank Portfolio
Committee on Banking supervision, July. Strategies Group report, December.
Belkin, B., S. Suchower and L. Forest, 1998a, Gordy, M., 2000, “A comparative anatomy of
“The effect of systematic credit risk on loan credit risk models,” Journal of Banking and
portfolios and loan pricing,” CreditMetrics Finance, 24(1/2): 119–149.
Monitor, April: 17–28.
Hayt, G., 2000, “How to price credit risk,” Risk
Belkin, B., S. Suchower and L. Forest, 1998b, “A Magazine, 13(2): 60–61.
one parameter representation of credit risk and Iscoe, I., A. Kreinin and D. Rosen, 1999, “An
transition matrices,” CreditMetrics Monitor, integrated market and credit risk portfolio
October: 46–56. model,” Algo Research Quarterly, 2(3): 21–37.
Brace, A., D. Gatarek and M. Musiela, 1997, Jarrow, R., D. Lando and S. Turnbull, 1997, “A
“The market model of interest rate dynamics,” Markov model for the term structure of credit
Mathematical Finance, 7(2): 127–155. risk spreads,” The Review of Financial Studies,
Brand, L. and R. Bahar, 1998, “Recovery on 10(2): 481–523.
defaulted bonds tied to seniority rankings,” Jarrow, R. and S. Turnbull, 2000, “The
Special Report Rating Performance 1997, intersection of market and credit risk,” Journal
Standard and Poor’s, August. of Banking and Finance, 24(1): 271–299.
CreditMetrics: The Benchmark for Understanding Jarrow, R. and S. Turnbull, 1995, “Pricing
Credit Risk, Technical Document, 1997, New derivatives on financial securities subject to
York, NY: JP Morgan, Inc. credit risk,” Journal of Finance, 50: 53–83.
Das, S., (ed.), 1998, Credit Derivatives: Trading Koyluoglu, H. and A. Hickman, 1998,
and Management of Credit and Default Risk. “Reconcilable differences,” Risk Magazine,
(Wiley Frontiers in Finance), New York: John 11(10): 56–62.
Wiley & Sons.
LPC Gold Sheets, 2000a, “M & A deals,” Loan
Das, S. and P. Tufano, 1996, “Pricing credit- Pricing Corporation, 14(23):14.
sensitive debt when interest rates, credit
ratings and credit spreads are stochastic,” LPC Gold Sheets, 2000b, “Investment grade
Journal of Financial Engineering, 5(2): 161–198. deals” Loan Pricing Corporation, 14(23):8–9.

Dembo, R., A. Aziz, D. Rosen and M. Zerbs, Lando, D., 1998, “On Cox processes and credit
2000, Mark-to-Future: A Framework for risky securities,” Review of Derivatives Research,
Measuring Risk and Reward, Toronto: 2(2/3): 99–120.
Algorithmics Inc. Lando, D., 1994, “Three essays on contingent
Duffie, D. and D. Lando, 1997, “Term structures claims pricing,” Ph.D. thesis, Graduate School
of credit spreads with incomplete accounting of Management, Cornell University.
information,” Working paper, Graduate Leland, H., 1994, “Risky debt, bond covenants
School, of Business, Stanford University. and optimal capital structure,” Journal of
Finance, 49: 1213–1252.
Duffie, D. and K. Singleton, 1999, “Modeling
term structures of defaultable bonds,” Review Li, D., 2000, “On default correlation: a copula
of Financial Studies, 12(4): 687–720. approach,” Journal of Fixed Income, 9(3): 43–
Eales, R. and E. Bosworth, 1998, “Severity of loss
in the event of default in small business and Longstaff, F. and E. Swartz, 1995a, “The pricing
larger consumer loans,” The Journal of Lending of credit derivatives,” Journal of Fixed Income,
and Credit Risk Management, 80(9): 58. 5(1): 6–14.

Credit risk valuation framework

Longstaff, F. and E. Swartz, 1995b, “A simple the right to choose when to obtain funds and
approach to valuing risky fixed and floating when to repay funds and how much to borrow,
rate debt,” Journal of Finance, 50(3): 789–819. within limits set by the contract. These limits
typically stipulate a maximum borrowing amount
Madan, D. and H. Unal, 1998, “Pricing the risks
(commitment), the date by which all borrowed
of default,” Review of Derivatives Research, 2(2/
funds must be repaid, and the covenants that the
3): 121–160.
borrower must satisfy to qualify for receiving
Merton, R., 1974, “On the pricing of corporate funds. In some cases, the agreement requires that
debt: the risk structure of interest rates,” the borrower periodically “clean up” (pay down
Journal of Finance, 29: 449–470. to a specified level) the facility before re-
Shearer, A. and L. Forest, 1998, “Improving borrowing. The revolving line involves all of the
quantification of risk-adjusted performance complications of the term loan plus the added
within financial institutions,” Commercial feature of granting the borrower the right to
Lending Review, 13(4): 48–57. choose when to borrow and in what amounts.

Tavakoli, J., 1998, Credit Derivatives: A Guide to Different types of revolving lines account for the
Instruments and Applications, Wiley Series in major share of bank lending to businesses. By
Financial Engineering, New York: John Wiley & providing funds virtually on demand, the
Sons. revolver allows a business to meet its working
capital needs and to manage the liquidity risk
Appendix 1: standard credit instruments created by volatile cash flows. By pooling
The simplest type of credit instrument is the revolvers across many businesses, a bank
(bullet) corporate bond (BD) in which the issuer eliminates through diversification most of the
obtains cash from the initial investors at liquidity risk that it inherits from customers.
origination and, in return, agrees to make Revolvers and term loans cover most of the
payments of interest and, at maturity, of principal lending that requires the creditor’s money. Other
to holders of the securities. Some bonds include standard types of credit instruments do not
sinking fund or redemption provisions basically normally involve the bank or non-bank creditor
equivalent to amortization of principal. Most actually lending money.
allow prepayment after a period of call
protection. The bond’s comparative simplicity In a financial letter of credit (LC), the creditor
makes it more readily marketable than other guarantees the repayment of a counterparty’s
credit agreements that, in contrast, often include obligation and, in return, receives a one-time or
clauses proscribing or limiting assignments. periodic fee. Thus, a bank could issue a financial
LC in support of a customer obtaining short-term
A term loan (TL) is a credit contract in which cash from a money market fund that offers an
the borrower receives funds from the creditor(s) attractive rate. In a financial LC, the bank
at contract closing or usually over a short period essentially provides credit insurance. The
following closing and, in return, agrees to make instrument’s contingent pay-offs mirror those of a
payments of interest, fees and principal based on credit default swap.
formulae and schedules specified in the
agreement. Term loans can be quite complicated, A banker’s acceptance (BA) is another type of
involving amortization of principal, differing payment guarantee. In a BA, the bank certifies
levels of seniority, posting of collateral, detailed that it will stand behind time drafts (post-dated
covenant restrictions, prepayment penalties and cheques) issued by a customer. The customer
interest and fees that may vary with the may then sell drafts endorsed as accepted by the
borrower’s risk rating or financial performance. bank at a discount to a funding source that does
Term loans, however, account for a minority not want to bear the issuer’s credit risk.
share of the lending by commercial banks.
LC and BA facilities usually allow the borrower
A revolver (RV), or credit line or revolving line, to choose when to make use of the credit support
is a credit agreement in which the borrower has offered by the bank. Thus, the outstanding

Enterprise credit risk using Mark-to-Future

amount under these instruments may “revolve” payments plus the gains (minus the losses) of the
in the same way as disbursed balances in a funded underlying instrument. As in the DS, the RS can
revolving line. involve counterparty risk in addition to the risk
In a credit-default swap (DS) the buyer pays a of the underlying instrument. Also, as in the DS,
one-time or periodic fee to the seller of the RS usually allows the protection buyer to
protection for the right, in the case of default by a cancel the agreement.
particular borrower, to receive cash
compensation or to sell a credit instrument We turn lastly to the most complex case, the
issued by the borrower at a specified price (near multi-option credit facility (MOF). In an MOF,
par). In contracts with extremely low-risk the borrower has access to a range of instrument
counterparties, this instrument offers basically types within a single facility or contract. In this
the same state-contingent cash flows as a case, the creditor commits to provide credit up to
financial LC. Otherwise, the instrument involves a maximum amount, which can amortize over
counterparty risk as well as the risk of the time, to be drawn on in various ways largely at
underlying instrument. As with a financial LC the borrower’s discretion. In a more general case,
and insurance contracts in general, the the borrower can receive a term loan and then, as
protection buyer in a DS typically has the right of needed, obtain additional credit up to the
cancelling (prepaying) the agreement. remaining commitment amount. This additional
In a total-return swap (RS) the protection buyer credit can take the form of additional funded
exchanges the total returns on a specified balances (revolvers), letters of credit, bankers’
underlying debt instrument for a set of stable acceptances, or some combination of these types.
cash flows. The protection seller receives cash Of course, an MOF can offer less than the full
flows that match the interest and principal menu of instrument types.

Appendix 2: summary of relevant cash flows

Variable Description Derivation

AC commitment amount N loan attribute from contract

OS total outstanding amount Y OSTL + OSRV + OSLC + OSBA

OSTL term loan outstanding amount N RUTL × AC

OSRV revolver outstanding amount Y RURV × AC

OSLC LC outstanding amount Y RULC × AC

OSBA BA outstanding amount Y RUBA × AC

Table A1: Selected balances affecting bank loan cash flows and exposures

Credit risk valuation framework

Description (beginning or Derivation
end of period)

CFUF upfront fee beginning upfront fee rate × commitment amount

CFPP prepayment beginning prepayment penalty rate × commitment amount


CFFF facility fee beginning facility fee rate × commitment amount

CFLC LC fee beginning LC fee rate × LC outstanding amount

CFBA BA fee beginning BA fee rate × BA outstanding amount

CFC operating beginning origination costs (t = 0 only) + servicing costs

costs + collateral monitoring cost
origination costs = fixed origination costs
+ marginal origination cost rate × commitment amount
servicing costs = fixed servicing costs + marginal cost rate
on outstanding × total outstanding amount + marginal cost
rate on undrawn × (commitment amount – total outstanding
collateral monitoring cost = fixed collateral monitoring cost
+ marginal cost rate on collateralized outstanding × collater-
alized outstanding amount

CFI interest end contractual interest rate × (term loan outstanding amount +
revolver outstanding amount)

CFCF commitment end commitment fee rate × (commitment amount

fee – total outstanding amount)

CFUT utilization fee end total outstanding amount × blended utilization fee rate

CFP principal end term loan outstanding end of period – term loan outstanding
repaid beginning of period; determined by loan contract

Table A2: Selected bank loan cash flow components

Enterprise credit risk using Mark-to-Future

Variable Description Derivation

RI contractual interest rate contractually specified fixed rate or minimum rate of

floating rate options

RUF upfront fee rate contractually specified

RCF commitment fee rate contractually specified

RFF facility fee rate contractually specified

RLC LC fee rate contractually specified

RBA BA fee rate contractually specified

RUT blended utilization fee rate computed from contractually specified utilization fee
schedule and current utilization as determined by
usage model

RPP prepayment fee rate contractually specified

Table A3: Selected pricing rates affecting bank loan cash flows

Variable Description Derivation

FCORIG fixed cost of loan origination estimated from pricing of small loans

MCORIG marginal origination cost rate imputed from secondary loan prices

FCSERV fixed cost of loan servicing imputed from pricing of small loans

MCSERVOS marginal servicing cost rate on total out- imputed from pricing of low-risk term loans
standing amount

MCSERVAC marginal servicing cost rate on undrawn imputed from undrawn pricing of low-risk loans

FCCOLL fixed cost of collateral monitoring imputed from pricing of small, secured loans

MCCOLL marginal cost rate of collateral monitoring imputed from default rates and pricing of
secured and unsecured loans

Table A4: Selected cost rates affecting bank loan cash flows

Credit risk valuation framework

Variable Description Derivation

RUTL term loan outstanding as percentage of loan attribute specified by contract

commitment amount

RURV funded revolver outstanding as percent- determined by usage model as influ-

age of commitment amount enced by the relative costs and antici-
pated usage rates of the different draw

RULC LC outstanding as percentage of commit- determined by usage model as influ-

ment amount enced by the relative costs and antici-
pated usage rates of the different draw

RUBA BA outstanding as percentage of commit- determined by usage model as influ-

ment amount enced by the relative costs and antici-
pated usage rates of the different draw

REURV anticipated revolver outstanding as per- loan attribute entered by analyst

centage of commitment amount

REULC anticipated LC outstanding as percentage loan attribute entered by analyst

of commitment amount

REUBA anticipated BA outstanding as percentage loan attribute entered by analyst

of commitment amount

Table A5: Selected utilization rates affecting bank loan cash flows

Appendix 3: marginal and market cost of The credit-line cost, CC, reflects the terms of the
credit loan contract. Consider, for example, a revolver
Let CC represent the marginal cost of credit with a drawn spread over the risk-free discount
under the existing credit line and let MC denote rate of RS, a commitment fee of RCF and no
the market cost, both expressed in basis points. other charges:
The net credit-line cost, N, is:
N = CC – MC
When the borrower draws, the interest-spread
We compute MC by solving for the spread that payments increase and commitment-fee
implies an NPV of zero on a one-period term loan payments simultaneously decrease. The marginal
issued by the borrower cost, CC, is computed by netting the two rates.
( 1 + R + MC ) ( 1 – PD ⋅ L )
0 = ----------------------------------------------------------------- – 1 – MCOS Suppose, alternatively, that the credit line is a
LC facility, with a LC fee of RLC and a facility
where, MCOS denotes the per-dollar cost of fee of RFF. Then,
servicing and monitoring the term loan, as
inferred from market pricing. Solving, we obtain 1+R
CC = RLC -------------------------
1 – PD ⋅ L
MC = ( P D ⋅ L + MCOS ) ------------------------- (A1)
1 – PD ⋅ L The factor applied to the RLC adjusts for that fee
Equation A1 shows that MC equals the sum of being paid in advance rather than in arrears. The
market-based credit and servicing costs, with facility fee is not substituted, since, unlike
some minor adjustments for payment timing and commitment fee payments, facility fee payments
exposure to default. do not decline with increasing line usage.

Enterprise credit risk using Mark-to-Future

Suppose that R = 6%, RS = 175bps, or priority in bankruptcy are required.

RCF = 45bps, PD = 2.5%, L = 30%, and Furthermore, given their mathematical
MCOS = 50bps. Then, tractability and similarities to terms structure
models, the intensity models lead in an elegant
CC = .0175 – .045 = .0130
way to Heath-Jarrow-Morton no-arbitrage
1 + 0.06
MC = ( 0.025 ⋅ 0.3 + 0.005 ) ------------------------------- = .01335 conditions for defaultable debt (see, for example,
1 – .025 ⋅ 0.3
N = CC – MC = – .00035 Duffie and Singleton 1999; Madan and Unal
Therefore, N = –3.5bps, which indicates a small
incentive to raise usage above initial The earliest reduced-form models deal with just
expectations. two credit states (default and no-default) and
make particular assumptions so as to obtain
Appendix 4: credit risk modelling
closed-form solutions for bond prices and
facilitate model calibration to observed credit
There are two common approaches to credit risk
spreads (e.g., Jarrow and Turnbull 1995; Duffie
modelling. The structural approach, originally
developed by Merton (1974), treats the firm’s and Singleton 1999). Lando (1994), Jarrow,
asset-value process and its capital structure as the Lando and Turnbull (1997) (JLT) and
underlying determinants of expected default Lando (1998) extend the reduced-form approach
rates. Equity and debt of the firm are seen as to the case of multiple, discrete, credit states or
options on the underlying firm’s value. These ratings. These models are sometimes referred to
models assume that default occurs if the firm’s as rating-based models.
asset value falls sufficiently below the value of its
debt. Instruments with credit risk to the firm are Under the JLT model, spreads are deterministic
modelled as derivatives of the firm’s asset value, since both the migration probabilities and the
and can therefore be priced using the Black- recovery rates are also deterministic. Das and
Scholes-Merton approach. Tufano (1996) (DT) extend the JLT model to
Early research in this area focused on developing allow for stochastic credit spreads that may also
explicit valuation formulae, given particular exhibit correlation to the risk-free term structure.
assumptions on the asset-value process and For mathematical simplicity, DT assume that
capital structure, and on comparing the values transition probabilities are deterministic and that
from those formulae with available market prices. recoveries follow a mean-reverting process.
More recent research attempts to explain
features of market pricing by introducing jumps The intuition behind the DT model is that
and informational imperfections into the stochastic credit spreads arise when the
valuation model (see, for example, Leland 1994; underlying default probabilities (or the
Longstaff and Swartz 1995a, 1995b; Duffie and
intensities) and/or the recovery rates are
Lando 1997; Madan and Unal 1998).
stochastic. Either one of these two conditions
The alternative reduced-form or intensity- alone can be used to fit the model to observed
based approach does not specify an underlying spread volatilities. Instead, Lando (1998) and
model of asset value and capital structure. Jarrow and Turnbull (2000) use Cox processes to
Instead, default is modelled as an unpredictable obtain stochastic intensities that also lead to
jump event governed by a stochastic intensity
stochastic spreads. Gaussian models generally are
process. The stochastic intensity processes
describing default events or, more generally, used only for tractability, although they may lead
credit-state transitions, are directly calibrated to to negative intensities in practice. Alternatively,
market prices. By defining recovery rates in the Duffie and Singleton (1999) propose modelling
event of default exogenously, no particular the intensities directly as a stochastic mean-
assumptions on the capital structure of the firm reverting process (perhaps with jump terms).