Designing and pricing of revenue derivatives layout

Abstract

In this paper we design and price revenue derivatives. We show that a fixed loan repayment is equivalent to a combination of a stochastic loan repayment and a revenue derivative. A fixed loan repayment is equal to a stochastic loan repayment and a short revenue call option. We compare the cost of the derivative and potential loss to the lender if default occurs without taking a position in the revenue derivatives. The calculations are based on default probabilities that we compute and assumed recovery rates. Lenders should include revenue derivatives in their portfolios to offset inherent credit risk whilst borrowers who experience fluctuating revenues use them to maintain a high credit quality.

Subject Classification:

• 60 Probability Theory and Stochastic Processes and 62 Statistics

Keywords:

• Revenue derivative
• Credit loss
• Stochastic loan repayment
• Martingale
• Revenue put option
• Expected loss
• Revenue call option