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On The Credit Risk Of Secured Loans With Maximum Loan-To-Value Covenants

Author

Listed:
  • Fabian Astic

    (Moody's Investors Service, Credit Policy/Research, 7 World Trade Center, 250 Greenwich Street, New York, NY 10007, USA)

  • Agnès Tourin

    (Department of Finance and Risk Engineering, New York University Polytechnic School of Engineering, Six MetroTech Center, Brooklyn, NY 11201, USA)

Abstract

We propose a framework for analyzing the credit risk of secured loans with maximum loan-to-value covenants. Here, we do not assume that the collateral can be liquidated as soon as the maximum loan-to-value is breached. Closed-form solutions for the expected loss are obtained for nonrevolving loans. In the revolving case, we introduce a minimization problem with an objective function parameterized by a risk reluctance coefficient, capturing the trade-off between minimizing the expected loss incurred in the event of liquidation and maximizing the interest gain. Using stochastic control techniques, we derive the partial integro-differential equation satisfied by the value function, and solve it numerically with a finite difference scheme. The experimental results and their comparison with a standard loan-to-value-based lending policy suggest that stricter lending decisions would benefit the lender.

Suggested Citation

  • Fabian Astic & Agnès Tourin, 2014. "On The Credit Risk Of Secured Loans With Maximum Loan-To-Value Covenants," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 17(08), pages 1-19.
    • Handle: RePEc:wsi:ijtafx:v:17:y:2014:i:08:n:s0219024914500551
    DOI: 10.1142/S0219024914500551
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    References listed on IDEAS

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    3. Chunsheng Zhou, 1997. "A jump-diffusion approach to modeling credit risk and valuing defaultable securities," Finance and Economics Discussion Series 1997-15, Board of Governors of the Federal Reserve System (U.S.).
    4. Thi Thanh Binh Dao, 2005. "Double Exponential Jump : A Structural Model," Post-Print halshs-00164806, HAL.
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