Modelling Prepayment and Default under Changing Credit Market Conditions for a Net Present Value Analysis

TL;DR

This paper introduces a comprehensive model for evaluating loan profitability by simultaneously considering prepayment and default risks influenced by credit market fluctuations, using the Random Net Present Value as a key metric.

Contribution

It presents a novel unified framework that captures borrower behavior and credit market dynamics to assess loan profitability under changing conditions.

Findings

Analysis of mean and variance of RNPV at individual and portfolio levels

Quantitative insights into the impact of market conditions on loan profitability

Framework applicable for risk management and pricing strategies

Abstract

A model is developed to assess the profitability of loans or mortgages with a specified repayment schedule. Financial institutions face two competing risks: default and prepayment, both influenced by the stochastic evolution of credit market conditions. This study focuses on the Random Net Present Value (RNPV) as a key performance metric. The analysis evaluates the mean and variance of the RNPV at both the individual loan level and the portfolio level, within a unified framework that accounts for borrower behavior and prevailing credit market dynamics.