Fee-Based Pricing of Fixed Rate Bank Loan Commitments

Fixed rate bank loan commitments are contingent claim liabilities that commercial banks issue to provide their customers with a right to borrow a limited amount of funds at a specified interest rate within a specified time period. These prearranged credit agreements are often referred to as credit lines. Although there are many types of loan commitments in use, we restrict our attention to fixed rate commitments which are paid for by cash fees. Hong and Greenbaum [7] have pointed out that a loan commitment can be viewed as a put option that banks sell to corporate customers giving them the right to sell debt to the bank at a specified price (interest rate) within a specified time period. Although there is a great body of literature covering the pricing of put and call options on common stock, the existing theory must be modified to incorporate the interactions among stochastic interest rates, loan values, and the prices of loan commitments. A theory of loan commitment pricing focusing on the relationship between the commitment's value and the uncertainty surrounding future interest rates is developed in detail