Hedda Giaever and Hanna Karlsson

Component based loan pricing - a generic approach to price credits

Abstract

This paper discusses how to find the profitability of a specific loan
and how to use this in the process of pricing credits. We evaluate how
to capture risk in the profitability measure, by including a cost of
risk and capital requirements due to risk. Furthermore we discuss how
all revenues and costs can be related to the allocated capital, in spite
of changes in capital requirements over the time to maturity. The
required allocated capital due to risk of a loan is affected by the
amortization structure and we discuss how the measure can incorporate
this. Additionally, we argue that costs and revenues should be time
adjusted, and the required return on loan investments is analyzed. The
profitability measure that includes all these components is eventually
used in a contextual framework for pricing credits. Finally a summary of
how some Swedish financial institutions price credits is discussed and
commented.