Abstract
This paper analyses the risk and return of loans portfolios in a joint setting. I develop a model to obtain the distribution of loans returns. I use this model to describe the investment opportunity set of lenders using mean-variance analysis with a Value at Risk constraint. I also obtain closed form expressions for the interest rates that banks should set in compensation for borrowers' credit risk under absence of arbitrage opportunities and I use these rates as a benchmark to interpret actual loans' prices. Finally, I study the risk-return trade-off in an empirical application to the Spanish banking system.
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