This paper proposes a valuation model for revolving credit agreements and loan commitments. Drawdowns and repayments are only partially predictable by the bank. The bank can claim the material adverse change condition. The firm can cancel the credit agreement by stopping the payment of usage fees. Contract complexity, uncertain drawdown and repayment give banks scope for‘strategic’ valuation of credit agreements for financial reporting and Tier 1 bank capital requirements. The requirement of measuring credit agreements at ‘the payoff from immediate drawdown’, rather than at ‘fair value’ as per IAS 37 and IAS 39, would reduce the scope for ‘strategic’ valuation.

This paper revisits the fair valuation of credit agreements between banks and corporations, such as Loan Commitments (LC) and revolving credit agreements (revolvers). Such valuation is a long-lasting issue, e.g., Thakor (1982) proposed option pricing formulae to price LC and Hawkins (1982) proposed a continuous time model to price revolvers. The fair valuation of these credit agreements has become even more topical in recent years, especially for banks, because it is required or permitted by the International Financial Reporting Standards (IFRS). According to IFRS loan commitments must be recognized as liabilities in the bank’s statement of financial position, i.e., in the bank’s balance sheet. Recognition of LC as liabilities may be preferable to relegating LC obligations off-balance sheet, but affects the measurement of the bank’s Tier 1 regulatory capital. According to the 2006 version of the Basel II Accord (in Annexure la), Tier 1 capital includes permanent shareholders’ equity and disclosed reserves of accumulated retained earnings or other surplus. Therefore, Tier 1 capital is affected by the recognition and fair valuation of LC mandated by IFRS. This concerns bank regulators: LC ‘fair’ valuation does not rely on marking to market, as LC have no observable prices in a liquid market, but on marking to market, LC model-based valuation may not be reliable and offer banks scope for ‘strategic’ valuation to boost Tier 1 capital. This whole argument is equally applicable to revolving credit lines.

Against this backdrop, this paper proposes a model to price both LC and revolvers as credit derivatives driven by the borrower’s default intensity. To the best of our knowledge the past literature has only proposed separate valuation models for LC and revolvers, despite the inherent similarity of such credit agreements. Revolvers allow the firm to borrow, payback and borrow again. LC allow the firm to borrow and payback, but not to borrow again. More specifically this paper prices LC and revolvers from the point of view of the bank, as suggested in Chava and Jarrow (2008), and the contribution lies in analyzing realistic conditions such as:

The fair value of drawdown options under the credit agreement is very sensitive to assumptions about the firm’s expected drawdown behavior. Drawdown is expected only when the firm can borrow more cheaply under the terms of the credit agreement than otherwise, but the firm is unlikely to borrow if it does not need the funds yet. Therefore, cheaper borrowing through the credit agreement only makes drawdowns probable. Drawdown uncertainty is a challenge for the fair valuation of credit agreements.

Financial Risk Management Journal, Bank Credit Agreements, Loan Commitments, LC, International Financial Reporting Standards, IFRS, Material Adverse Change, MAC, Credit Derivatives, Credit Agreements, Classic Lognormal Assumption.