A Risk-Neutral Approach for the Evaluation of Commercial Loans

Abstract

This paper describes a new methodology that allows the Banks to evaluate the loans using a risk neutral approach. More in detail it illustrates the methodological framework behind the definition of the risk neutral default probabilities used to estimate the loans credit spreads. These risk neutral probabilities are calculated using a contingent-claims approach conceptually similar to the Black-Scholes and Merton framework for modelling corporate liabilities. The proposed risk neutral approach is suitable at producing estimates, in a fair value computation context, that are as close as possible to the exit price as mandated by IFRS 13 with a lower dependency on internal parameters. It is compatible with the income approach, usually adopted for the loans evaluation, and is coherent with the discounted cashflows methodologies used for the pricing of securities subject to default risk. Under this approach, the cashflows riskiness is kept into account applying weights to the discount factors so as to consider a credit and time value in the spread calculation.