Recent years have seen a gradual movement in accounting standards and regulation towards valuing loans at fair value in a more forward-looking manner. For example, IFRS 9 accounting rules require that loans use a forward-looking expected credit loss model to increase the timeliness of loss recognition and maximise the use of relevant observable market data. However, this is a difficult task as loans are typically not traded and consequently there are no directly observable market prices.
This paper outlines a risk-neutral valuation of loans, maximising the use of available market data (for example, yield curves, CDS curves and interest rate option volatilities). This approach can be used to consistently value loans taking into account the cashflows, default and recovery process and prepayment and remuneration optionality. Changes in regulation and accounting, such as the implementation of IFRS 9, together with market changes, such as significant negative interest rate probability, are likely to lead to an increase in the use and applicability of such approaches.