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Corporate Credit Risk Valuation Using Option Pricing Theory Methodology - a Practical Application to a Banking Credit Portfolio

This paper explores the application of the advances in finance by using option pricing methodology in the evaluation of corporate credit risk in a sample banking credit portfolio. More specifically, the goals pursued in the paper are the valuation of the absolute value of each credit position, and hence what is the corresponding "economic" credit risk, the valuation of different types of credit positions (with different maturities, covenants, repayment schedules, guarantees, interest-rate resetting processes and renegotiation aspects), the impact of refinancing risk in valuation, the valuation of the credit portfolio diversification effect on the overall credit portfolio, and the determination of the adequate "economic" capital to cover the expected losses (credit risk) of the portfolio. The valuation technique is based in a risk-neutral valuation binomial tree process applied to the firm value from which all contingent claims on the firm can be valued. The binomial approach is revealed to be a powerful method to value complex and multiple debt issues on the same firm.