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Optimal Loan Interest Rate Contract Design

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  • Edelstein, Robert
  • Urosevic, Branko

Abstract

This paper analyzes optimal loan interest rate contracts under conditions of risky, symmetric information for one-period (static) and multi-period (dynamic) models. The optimal loan interest rate depends upon the volatility of, and co-variation among the market interest rate, borrower collateral, and borrower income, as well as the time horizon and the risk preferences of lenders and borrowers. For a risk-averse borrower with stochastic collateral, variable interest rate contracts are, in general, Pareto optimal. For plausible assumptions, the optimal loan interest rate for the multi-period model often exhibits "muted" responses to changes in market interest rates, making fixed rate loans a reasonable approximation for the optimal loan. Hence, in the absence of optimal contracts, long-term (short-term) borrowers tend to prefer fixed rate (variable) contracts. Copyright 2003 by Kluwer Academic Publishers

Suggested Citation

  • Edelstein, Robert & Urosevic, Branko, 2003. "Optimal Loan Interest Rate Contract Design," The Journal of Real Estate Finance and Economics, Springer, vol. 26(2-3), pages 127-156, March-May.
    • Handle: RePEc:kap:jrefec:v:26:y:2003:i:2-3:p:127-56
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    Cited by:

    1. Pantelous, Athanasios A., 2008. "Dynamic risk management of the lending rate policy of an interacted portfolio of loans via an investment strategy into a discrete stochastic framework," Economic Modelling, Elsevier, vol. 25(4), pages 658-675, July.
    2. Ebrahim, M. Shahid & Mathur, Ike, 2007. "Pricing home mortgages and bank collateral: A rational expectations approach," Journal of Economic Dynamics and Control, Elsevier, vol. 31(4), pages 1217-1244, April.
    3. Jan K. Brueckner & Kangoh Lee, 2014. "Optimal Risk-Sharing in Mortgage Contracts: The Effects of Potential Prepayment and Default," CESifo Working Paper Series 4979, CESifo.
    4. Vickery, James, 2008. "How and why do small firms manage interest rate risk," Journal of Financial Economics, Elsevier, vol. 87(2), pages 446-470, February.

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