Private Debt

CHAPTER 8Loans and the Theory of Credit

Much of the credit research presented thus far has been empirical, using historical data to drive an understanding of credit return and risk. However, credit can also be understood from a theoretical perspective, using option‐pricing theory to explain and measure credit return and risk. This chapter reviews some basic theoretical underpinnings of credit and ties its conclusions to market behavior.

The chapter begins with a review of the Merton model for pricing corporate debt; shows how it can be applied to calculate credit risk premiums for middle market corporate loans, including sensitivity analysis; estimates credit risk using Monte Carlo simulation; and finally, tests risk findings against historical risk measures.

This research approach can be helpful in several ways. For example, understanding the Merton model better informs investors of loan pricing and its determinants. Take the tightening of yield spreads for credit securities relative to comparable maturity Treasury securities (also called spread compression), for example, which is generally attributable to capital inflows but instead could be explained by a rise in the risk‐free rate. Another application is determining return and risk expectations for less familiar debt instruments such as second‐lien and mezzanine loan structures, which can be estimated through simulation techniques where empirical data is not available.

To better understand the implications of the current ...