PRICING ON AMORTIZING LOAN

THAT IS BASED ON CASH FLOW AT RISK APPROACH

Ihor Voloshyn

January 2014

Version 2

Ihor Voloshyn
PhD, PJSC "Kreditprombank"
38, Druzhby Narodiv Boulevard,
01014, Kiev, Ukraine
Tel. +38 050 358 6314
vologor@i.ua

The paper has been published in Herald of National Bank of Ukraine 2013, No 6(208).
http://bank.gov.ua/doccatalog/document?id=1564774

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Electronic copy available at: http://ssrn.com/abstract=2344117

Abstract
In the paper, different approaches to pricing on loan are compared. Cash Flow at Risk
approach to loan pricing is suggested. Application of this approach ministers to protect a
bank against both credit and liquidity risks, and to receive by it interest income with interest
rate that is not less than the guaranteed one. Example of interest rate on loan calculation is
given. The suggested approach is easy included into RAROC approach.

Key words: credit risk, pricing, loan, probability of default, loss given default, cash flow at risk,
liquidity premium, credit premium, expected losses, risk-adjusted return on capital (RAROC),
present value, liquidity risk

JEL Classifications: G12, G21

2
Electronic copy available at: http://ssrn.com/abstract=2344117

1. INTRODUCTION

Loan pricing is one of the important stages of credit process and management of credit risk.
Whether a bank will receive adequate return for the taken credit risk and its borrowers will do
accessible and attractive loan prices depends on how the bank sets prices on its loans. As is
known, the overvaluation of credit risk by banks restrains credit expansion, and its
underestimation leads to the accumulation of credit risk in banks. Therefore, the right loan
pricing opens the way to credit expansion and increases protection against credit risk.
Note that credit risk influences not only on the level of expected loan losses, i.e. on
banks capital, but also on its liquidity. In this paper, liquidity risk is examined as that is
exceptionally induced by credit risk. It is a risk that losses of cash flows will happen.
The modern approaches to loan pricing are more oriented to estimate affecting credit risk
on the loan value than on bank liquidity. The best practices of integrated risk management
recommend to take into account the mutual interaction of risks. The known experts on credit
risks Bohn and Stein (2009) state that the most credit risk models have underestimated credit risk,
because they do not take into consideration a liquidity premium. Meantime, the world financial
crisis 2007-2008 years, when liquidity of financial markets has quickly evaporated, showed
importance of account of liquidity premiums. Bohn and Stein (2009) assert that now there are no
fully developed models for loan pricing, taking into account the liquidity risk. Therefore, this
article is devoted development of approach to loan pricing, coming from the task of integrated
management of credit and liquidity risk of a bank. And so, a suggested approach allows
answering how a bank through pricing can be defended against both credit and liquidity risks.

2. BASIC APPROACHES TO LOAN PRICING

Among the great number of the modern approaches to loan pricing, consider only three
approaches which are based on present value conception, on the RAROC approach, and on the
cash flow at risk one.
According to the present value conception, a risky interest rate (as compared to a risk
free one) should compensate the losses of the time value of money and the expected losses due to
credit risk. Then, the risky interest rate on loan is found from the following condition: the present
value of risky loan is equal to the present value of risk free one:

PV risky PV risk free , (i)

where PVrisky is the present value of risky loan, PVrisk-free is the present value of risk free loan.

Flannery (1985) maybe one of the first economists who had offered such a risk-neutral
approach to loan pricing. Lets consider the one year bullet risky loan where a payment of the
principal and interest is due at the end of the loan term. For this loan, the risky interest rate is
equal to (Flannery, 1985; Sinkey, 1998; Curcio and Gianfrancesco, 2009):
R

r el
, (ii)
1 el

where R is the risky interest rate, r is the risk free interest rate, el is the specific (on unit of loan
sum) expected losses (Bessis, 1988; Bohn and Stein, 2009):
el=pdlgd, (1)
where pd is the probability of borrowers default, lgd is the specific (on unit of loan sum) loss
given default.
Thus, this loan pricing technique is based on discounting the projected cash flows. But
for taking into account influence of credit risk on liquidity risk it is necessary to use the future
undiscounted cash flows. Because, the banks liquidity depends exactly on them (Voloshyn,
2004; Seward, 2010).
RAROC approach to loan pricing is based on the fact that the interests should cover the
expected loan losses, the cost of funds, the operating expenses, and provide the target riskadjusted return on capital. According to this approach, the risky interest rate on loan is calculated
as follows (Bessis, 1988):

R r el , (2)
where r is the guaranteed interest rate, which guarantees coverage of the cost of funds, the
operating expenses, and provides the target value of RAROC (Bessis, 1988):
r = i+oc+(RAROC-i)EC,
where i is the cost of funds or the interest rate on which a loan is financed, oc is the specific (on
unit of loan sum) operating expenses, EC is the specific (on unit of loan sum) economic capital,
RAROC is the given target return on economic capital.
Note that this approach utilizes the following implicit assumption: reduction of
performing loans, caused by credit risk, is neglected. As a result, the interest income appears to
be overvalued. Correspondingly, the risky interest rate occurs to be underestimated. Advantage
of this approach is that the cash flows are not discounted explicitly.
Voloshyns (2012) proposed approach to loan pricing based on approach cash flow at
risk. They put the following principle of pricing: an extra interest income from a credit
premium should cover a loss of future undiscounted cash flows, caused by credit risk, over all
lifetime of loan (Fig. 1). Note that the loss of the future undiscounted cash flows is cash flow at
risk.

Thus, the value of the cumulative cash flow at risk, that is estimated over the loan
lifetime, should be equal to the difference of the interest incomes on the risky loan and on the
one with the guaranteed interest rate r, which the bank expects to receive , namely:
CFaR II II risky II guarant, (3)

where CFaR is the cumulative cash flow at risk that the bank can lose due to credit risk at the
time of the loan maturity, II is an extra interest income from a credit premium, II risky is the
interest income on the risky loan:
II risky B proj R , (4)

where B proj is the average projected balances of performing loans (on which the borrowers pay
both principles and interests), R is the contractual risky interest rate on the loan, IIguarant is the
guaranteed interest income that the bank expects to receive on the loan;
II guarant B contr r , (5)

where B contr is the average over the loan life contractual balances of the loan, r is the guaranteed
interest rate on the loan.
From a formula (3), taking into account expressions (4 and 5) find the unknown risky
interest rate (Voloshyns, 2012):
R

CFaR B contr r . (6)

B proj

Thus, the premium for credit risk is equal to:

premium R r

CFaR B contr B proj

r . (7)
B proj
B proj

The first member in the right part of equation (7) is responsible for influence of credit
risk on the cash flows, and the second one answers for the cash flows of interests due to the
change of the balances.

Guaranteed
interest income
on interest rate r
Cumulative cash

Extra interest

flow at risk,

income from

CFaR

credit premium

Cumulative cash

Interest income
on risky loans
on interest rate R

flows according
to contractual

Cumulative

term to maturity

guaranteed cash
flows that bank
expects to receive

Fig. 1. Conception of coverage of cash flow at credit risk by extra interest income from credit
premium (Voloshyns, 2012).

3. PRICING OF AMORTIZING LOAN

Apply the cash flow approach to amortizing loan. For this purpose, write down the row of
indexes that are necessary to estimate the risky interest rate. Define the projected cash flows
CFt projd as follows:

CFt proj CFt contr csrt , (9)

where CFt contr is the contractual cash flows of principle at contractual term to maturity t, csrt is
the cumulative survival probability that a borrower does not take default at any time until to time
t.
Write down the cumulative survival probability csrt for the case when the marginal
probability of default pd does not depend on time, i.e. the credit rating of the borrower remains
unchanging (Lobanov and Chugunov, 2003):

csrt (1 pd ) t , (10)
where pd is the marginal probability of default in the time interval (t-1, t).
Then the cumulative cash flow at risk (CFaR) is equal to:
T

CFaR CFt contr ( 1 csrt ) , (11)

t 1

The contractual balance of loan Btcontr at time t are equal to:

t

Btcontr B0contr CFkcontr , (12)

k 0

where B0contr is the contractual balance of loan at time t=0.

The projected balance of the performing loan Btproj at time t, on which the borrower pays
both principle and interests, are equal to:

Btproj Btcontr csrt , (13)

The average values of the contractual and projected balances are found by the following
formulas:

B contr

1 T 1 contr
1 T 1
Bt , B proj Btproj ,
T t 0
T t 0

where T is the term to the loan maturity.

4. EXAMPLE OF LOAN PRICING

Bring the example of pricing of the one year loan with monthly amortization of principle and
interest payments, and with fixed interest rate R. The loan sum is equal 1200.00 US dollars.
Assume the guaranteed interest rate is equal to 25% per year. The borrowers credit rating does
not change in time. Thus, the probability of borrowers default during one month is equal to
pd=1%. The loan is unsecured: lgd = 1. The given data is characteristic for Ukrainian consumer
lending market.
The results of estimation of the contractual and projected cash flows, balances and
interest incomes are given in Table 1.

Table 1. The contractual and projected cash flows, balances and interest incomes on the loan.
Month,
t

Cumu-

Contra-

Cash

Projected

Contra-

Guaran-

Projected

Risky

Difference

lative

ctual

flow

cash

ctual

teed

balances,

interest

of incomes:

survival

cash

at

flows,

balances,

interest

Btproj

income,

IIrisky

probability,

flow,

risk,

CFt contr

CFt proj

risky

income,

Btcontr

guarant

II

II

guarant

CFaR

II

csrt
(10*)

(9*)

(12*)

(4*)

1 200.0

(13*)

(5*)

(3*)

100.0%

99.0%

100.0

1.0

99.0

1 100.0

25.0

1 078.1

37.9

12.9

98.0%

100.0

2.0

98.0

1 000.0

22.9

970.3

34.4

11.5

97.0%

100.0

3.0

97.0

900.0

20.8

864.5

31.0

10.1

96.1%

100.0

3.9

96.1

800.0

18.8

760.8

27.6

8.9

95.1%

100.0

4.9

95.1

700.0

16.7

659.0

24.3

7.6

94.1%

100.0

5.9

94.1

600.0

14.6

559.2

21.0

6.5

93.2%

100.0

6.8

93.2

500.0

12.5

461.4

17.9

5.4

92.3%

100.0

7.7

92.3

400.0

10.4

365.4

14.7

4.3

91.4%

100.0

8.6

91.4

300.0

8.3

271.3

11.7

3.3

10

90.4%

100.0

9.6

90.4

200.0

6.3

179.1

8.7

2.4

11

89.5%

100.0

10.5

89.5

100.0

4.2

88.6

5.7

1.6

12

88.6%

100.0

11.4

88.6

0.0

2.1

0.0

2.8

0.7

Total:

1 200.0

75.2

1 124.8

237.7

75.2

Average value:

1 188.0

162.5
650.0

620.5

* number of formula
From data of Table 1, cumulative cash flow at risk is equal to CFaR = 75.2 US dollars.
The average values of the contractual and projected balances is equal to B contr 650.0 US
dollars and B proj 620.5 US dollars, accordingly. The guaranteed interest rate is equal to r =
25% per year. Then, the risky interest rate on loan is equal to (formula (6)):
R

75.2 650.0 25% / 100%

100% 38.3% .
620.5

The credit premium is equal to (formula (7)):

premium = 38.3%-25.0%=13.3%.
Note that it contains liquidity premium that will be extracted later.
Calculate risky rate by traditional methodologies. So, the probability of borrowers
default during one year is equal to:
pd 1 csr12 1 88.6% / 100%100% 11.4% .

Taking into account that lgd = 1, the specific expected losses is estimated as el = pdlgd
= 11.4%. Then, using formula (2), the interest rate on the loan is equal to:
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R 25% 11.4% 36.4% .

According to present value approach discounting the future cash flows at the effective
rate reff= 25 % and equating the present values of loans with the guaranteed interest rate and the
risky loans (from equations (14)), get R =36.96 %.
T 1

t 0

CFt contr Btcontr r / 12 T 1 CFt pred Btpred R / 12

. (14)

1 reff / 12t
1 reff / 12t
t 0

Table 2. Comparison of risky interest rates on loan which are calculated by using different
approaches
Approach to loan pricing:
Indexes

Risky interest rate, R

Present value

RAROC

Cash flow at risk

(1)

(2)

(3)

36.96%

36.4%

is

1.34%

1.9%

differences of risky interest

(3-1)

(3-2)

Liquidity

premium

38.3%

rates which are calculated

using Cash Flow at Risk
approach and traditional
ones
As is obvious from data of Table 2, as compared to cash flow at risk approach the
present value technique and RAROC method give the underestimated values of the risky
interest rate for loan. Thus, the traditional approaches do not provide coverage of losses of cash
flows due to credit risk. As a result, the bank can not exactly control influence of credit risk on
liquidity that, in its turn, can result in the loss of bank liquidity.
The differences between the risky interest rates, which are estimated by cash flow at
risk approach and by the traditional ones, are the liquidity premiums.
The offered cash flow at risk approach guarantees the receipt (instead the accrual) of
interest income from credit operation with return that is not below than the guaranteed interest
rate.
An extra interest income from credit premium enables to form the liquidity buffer which
covers the possible losses of cash flows due to credit risk (Fig. 2). Note that the obligatory
condition of the effective credit and liquidity risk management is maintenance of liquidity buffer
on the level of cumulative cash flow at risk:

LB CFaR .

Extra interest
income from credit
premium, II

Liquidity buffer,
LB

Cash flow at credit

risk, CFaR

Fig. 2. Mechanism of coverage of cash flow at risk by extra interest income from credit
premium.
Due to usage of the guaranteed interest rate, the offered approach is easy included in riskadjusted return on capital (RAROC) approach. Thus, evolution of approaches to loan pricing it is
possible to present as the next chart (Fig. 3).
1. Compensation of losses of the time value of money and the expected loan losses

2. Compensation of expected loan losses and taking into consideration economic capital
(RAROC)
3. Compensation of losses of cash flows or cash flow at credit risk (CFaR)
Fig 3. Evolution of approaches to loan pricing.

5. SUMMARY
Cash flow at credit risk approach to loan pricing is developed. The suggested approach is
based on the following principle: a value of cumulative (over all lifetime of loan) cash flow at
risk should be equal to a difference of interest incomes on risky loan and on the one with a
guaranteed (expected to receipt) interest rate. Thus, both credit risk and liquidity risk, caused by
credit risk, become covered.
A distinguishing feature of the approach is that it utilizes undiscounted cash flows. The
pricing approach allows finding a liquidity premium. The proposed pricing method is easy
included into RAROC conception.
Further, it seems to be useful to investigate influence of funding through liabilities with
mutual maturities on loan price.

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LITERATURE

Bessis, J. (1988) Risk Management in Banking. West Sussex: Wiley & Sons Inc.

Bohn, J. R., Stein, R. M. (2009) Active Credit Portfolio Management in Practice. Hoboken,
New Jersey: Wiley & Sons Inc.

Curcio, D., Gianfrancesco, I. (2009) Bank loans pricing and Basel II: a multi-period riskadjusted methodology under the new regulatory constraints.
http://businessperspectives.org/journals_free/bbs/2009/BBS_en_2009_4_Curcio.pdf
retrieved on 21.10.2013

Flannery, M. J. (1985) A Portfolio View of Loan Selection and Pricing, in Eisenbeis, R.A.
and Aspinwall, R.C. (eds.), Handbook for Banking Strategy. New York: John Wiley and
Sons.

Lobanov, A. A., Chugunov, A. V. (2003) Financial risk management encyclopedia. Moskow:

Alpina.

Seward,

P.

(2010)

FX

Currency

Hedging:

Applying

Cash

Flow

at

Risk.

http://www.gtnews.com/Articles/2010/FX_Currency_Hedging__Applying_Cash_Flow_at_R
isk.html

Sinkey Jr., J.F. (1998), Commercial Bank Financial Management. In the Financial Services
Industry. New Jersey: Prentice-Hall International Inc.

Voloshyn, I. V. (2004) Estimation of banking risks: new approaches. Kyiv: Elga, NikaCentre.

Voloshyn, I. V., Voloshyn, M.I. (2012) Integrated risk management in a commercial marketmaker

bank

using

the

"cash

flow

at

risk"

approach.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2205570

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