Journal of Business Finance & Accounting, 33(7) & (8), 1298–1320, September/October 2006, 0306-686X doi: 10.1111/j.1468-5957.2006.00619.x Pricing the Credit Risk of Secured Debt and Financial Leasing Marco Realdon ∗ Abstract: This paper presents closed form solutions to price secured bank loans and financial leases subject to default risk. Secured debt fair credit spreads always increase in the debtor’s default probability, whereas financial leasing fair credit spreads may well decrease in the lessee’s default probability and even be negative. The reason is that the lessor, unlike the secured lender, can gain from the lessee’s default, especially when the leasing contract envisages initial prepayments or the lessee’s terminal options to either purchase the leased asset or to extend the lease maturity. This result, which critically depends on contractual and bankruptcy code provisions, can explain some of the empirical evidence and the use of financial leases as an alternative to secured bank lending to finance small, risky and relatively opaque firms. Keywords: default risk, secured debt, debt valuation, collateral asset, leasing valuation, leasing options. 1. INTRODUCTION AND LITERATURE Secured bank loans and financial leasing contracts are considered by the renegotiated Basel accord on the capital requirements of financial institutions. The new accord makes capital requirements depend on the credit risk of the institution’s assets. This has spurred interest in modelling the credit risk of secured loans and financial leases. This work intends to contribute to such modelling effort by proposing simple formulae to price secured bank loans and financial leases that are subject to the risk of default. According to Brealey, Myers and Allen (2005) ‘in many respects, a financial lease is equivalent to a secured loan’, but ‘... lessors and secured creditors have different rights when the asset user gets into trouble.’ 1 Indeed the present analysis highlights how the credit risk of financial leases is profoundly different from the credit risk of secured loans. * The author is from the University of York. He thanks an anonymous referee for suggesting substantial improvements to the previous drafts of this paper. (Paper received March 2005, revised version accepted January 2006. Online publication June 2006) Address for correspondence: Marco Realdon, Department of Economics and Related Studies, University of York, Alwin College, Heslington Y010 5DD, UK. e-mail: mr15@york.ac.uk 1 Brealey Myers and Allen (2005, pp. 708–09). C  2006 The Author Journal compilation C  2006 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA. 1298