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Call Options, Points, and Dominance Restrictions on Debt Contracts

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  • Kenneth B. Dunn
  • Chester S. Spatt

Abstract

We analyze the impact of a contract's length, callability, amortization, and original discount by arbitrage methods. Among instruments that are callable without penalty, longer instruments command a higher interest rate because the borrower possesses the option of repaying relatively more slowly. However, the rate on longer self‐amortizing loans cannot be substantially larger than for shorter ones because the payments decrease with contract length. Bounds on the trade‐off between points and rate for callable debt are characterized using the trade‐off for noncallable debt and the property that the value of the prepayment option increases with the loan's interest rate.

Suggested Citation

  • Kenneth B. Dunn & Chester S. Spatt, 1999. "Call Options, Points, and Dominance Restrictions on Debt Contracts," Journal of Finance, American Finance Association, vol. 54(6), pages 2317-2337, December.
    • Handle: RePEc:bla:jfinan:v:54:y:1999:i:6:p:2317-2337
    DOI: 10.1111/0022-1082.00190
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    Cited by:

    1. Longstaff, Francis A., 2002. "Optimal Recursive Refinancing and the Valuation of Mortgage-Backed Securities," University of California at Los Angeles, Anderson Graduate School of Management qt19k7479t, Anderson Graduate School of Management, UCLA.
    2. Amromin, Gene & Huang, Jennifer & Sialm, Clemens, 2007. "The tradeoff between mortgage prepayments and tax-deferred retirement savings," Journal of Public Economics, Elsevier, vol. 91(10), pages 2014-2040, November.
    3. Jonathan B. Berk, 1999. "A Simple Approach for Deciding When to Invest," American Economic Review, American Economic Association, vol. 89(5), pages 1319-1326, December.
    4. Sonin, Isaac M. & Whitmeyer, Mark, 2020. "Some nontrivial properties of a formula for compound interest," Finance Research Letters, Elsevier, vol. 33(C).
    5. Francis A. Longstaff, 2004. "Optimal Recursive Refinancing and the Valuation of Mortgage-Backed Securities," NBER Working Papers 10422, National Bureau of Economic Research, Inc.
    6. Gene Amromin & Jennifer Huang & Clemens Sialm & Edward Zhong, 2018. "Complex Mortgages [Why don’t lenders renegotiate more home mortgages? Redefaults, self-cures, and securitization]," Review of Finance, European Finance Association, vol. 22(6), pages 1975-2007.
    7. David, Alexander, 2001. "Pricing the strategic value of putable securities in liquidity crises," Journal of Financial Economics, Elsevier, vol. 59(1), pages 63-99, January.
    8. Isaac M. Sonin & Mark Whitmeyer, 2018. "Some Nontrivial Properties of a Formula for Compound Interest," Papers 1809.10566, arXiv.org.

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