Fixed Rate Loan Commitments, Take-Down Risk, and the Dynamics of Hedging with Futures

Abstract

This paper develops a normative model to analyze the hedging and fee-pricing decisions of a financial institution supplying fixed rate loan commitments to its customers. In supplying fixed rate loan commitments, the financial institution (hereafter referred to as bank) is assumed to act as an agent that transforms commitment risk through the use of financial futures contracts. While most pre? vious loan commitment models have analyzed the interest rate (or price) risk the bank faces in supplying fixed rate loan commitments, they either have ignored or assumed away the loan take-down (or quantity) risk.l In general, by making a formal, fixed rate loan commitment, the bank exposes itself to both a price and a quantity risk. Specifically, a formal loan com? mitment prespecifies the maximum size of the loan, the purpose of the loan (of? ten project-specific) as well as the interest rate and fee to be paid by the borrower [14], [15]. However, while a formal loan commitment imposes a contractual re? quirement on the bank to supply funds, up to a maximum amount at an agreed rate of interest, the expected size of the loan to be taken down is often uncertain. The reason is that for project-specific lines of credit, the amount taken down will depend on the future state(s) of the world that are revealed to the borrower at the end of the commitment period as well as on the limitations and constraints im? posed on the use of funds in the loan commitment contract. For example, construction delays and other market imperfections that hamper a planned invest?