Small businesses and risk contingent credit

Purpose – Firms facing significant income volatility can often suffer from downside risk such that return on assets is insufficient to meet fixed financial obligations. The purpose of this paper is to provide a prescriptive credit solution for small businesses facing exogenous income risk. Design/methodology/approach – Formulas for risk‐contingent operating and collateralized loans are developed and simulated in the context of a specific business sector. Findings – The paper demonstrates that a structured credit product with an imbedded option can reduce or eliminate financial risks by providing payouts that decrease the amount of principal and/or interest that firms must repay under low income states. Originality/value – The overall objective of this paper is to provide a means to mitigate exogenous income risk faced by firms through the design and application of a risk‐contingent credit product that is tied to primary markets and simple to implement. In this context, risk contingency credit refers to a suite of financial products with payoff schedules (loan principal) that are linked to specific commodities or indices. The authors are in fact unaware of any commercial financial products of the type considered in this paper and thus their approach is a prescriptive solution to the identified problem.