Credit risk Based on Firm Conduct - Performance and Bank Lending Decisions: A Capped Call Approach

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Title:	Credit risk Based on Firm Conduct - Performance and Bank Lending Decisions: A Capped Call Approach
Authors:	Tsai, Jeng-Yan;Chang, Chuen-Ping
Contributors:	淡江大學國際企業學系
Keywords:	Pricing;Credit risk;Firm conduct-performance;Bank lending;Capped call
Date:	2012-08
Issue Date:	2013-01-08 22:51:59 (UTC+8)
Publisher:	Journal of Applied Finance and Banking Herts: Scienpress Ltd
Abstract:	This paper models loan rate-setting behavior, taking into account the product pricing and performance of the borrowing firm, and also calculates the bank’s loan-risk sensitive equity values. The lending function creates the need to model bank equity as a capped call option, which captures the credit risk directly related to management of a firm’s operations. When the product price set by the borrowing firm is relatively high and the loan rate set by the bank is relatively low, a rise in the product price increases the loan amount at a reduced margin. A capped call as such makes the bank less prudent and more prone to risk-taking, thereby adversely affecting the stability of the banking system. We also show that the market-based estimates of bank equity, which ignore the cap, lead to significant overestimation.
Relation:	Journal of Applied Finance & Banking 2(4), pp.69-84
Appears in Collections:	[Graduate Institute & Department of International Business] Journal Article

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