Pricing loan cancellation option

difflab2000 · June 3rd, 2010, 6:00 am

A bank loan (for e.g. a company) usually looks something like:100 MEUR 5y loan. Up-front fee Xbps and interest Euribor + credit spreadUnlike many bonds, a loan can be cancelled by the company at any time (or within e.g. 1 year) and one can assume that the company will cancel the loan if it can refinance cheaper.Is there any standard method for pricing the embedded cancellation option in a loan like this?Appreciate any help or leads

frattyquant · June 3rd, 2010, 7:22 am

By "cancelled" I'm assuming you mean paid back. Wouldn't there just be a prepayment penalty(or none at all)?

difflab2000 · June 3rd, 2010, 7:27 am

Yes I mean the loan is paid back. There could be a prepayment penalty in some cases but not always.My first idea was to look at this as a bermudan swaption with the credit spread as the underlying, but not sure that is the correct way or what volatility to use as input (CDS spread vol)?I'm not looking for a "tradable price" but rather an indication telling me if the option is worth 1% or 5% of notional...

pcaspers · June 3rd, 2010, 8:45 am

The cancellation right is an option to receive Euribor + Loan Spread and pay Euribor + Current Spread ( + penalty ) from the view of the company, so in facht an option on a CDS with strike = Loan Spread. For european options usually a Black Scholes model is used for valuation with the spread volatility as input. The determination of the spread volatility will be difficult. As you are only looking for an indication perhaps you can use an analytical approximation for bermudan / american options with the spread vol set to some expert guess.