Managing the risk of embedded options in non-traded credit using portfolio modeling

A framework for measuring and managing the risk of embedded options in non-traded credit is developed. For typical bank clients there is no market information related to their ability to pay (bond or CDS spreads) available. The absence of market information is a key assumption of this paper. In this case, a bank has to rely solely on statistical data to judge the credit quality of a borrower. To value a loan with embedded options like prepayment rights, a model is proposed that combines an interest rate derivatives pricing model with statistical information on default and recovery rates. Using this for evaluating the risk of embedded options in loans, it is shown how the concepts of credit risk management can be applied after defining a suitable concept of risk. It turns out that this modeling framework combines the theories of derivatives pricing and credit risk modeling in the sense that derivatives pricing theory measures the costs for hedging optional components in loans while credit risk modeling measures the risk that these hedging costs turn out to be inadequate. This risk depends not only on the single loan's risk characteristics but also on the dependence structure and the granularity of the total loan portfolio.