Valuation Of The Prepayment Option In The Banking Book

We investigate in this paper a perpetual prepayment option related to a corporate loan. The short interest rate and default intensity of the firm are supposed to follow Cox–Ingersoll–Ross (CIR) processes. A liquidity term that represents the funding costs of the bank is introduced and modeled as a continuous time discrete state Markov chain. The prepayment option needs specific attention as the payoff itself is a derivative product and thus an implicit function of the parameters of the problem and of the dynamics. We prove verification results that allows to certify the geometry of the exercise region and compute the price of the option. We show moreover that the price is the solution of a constrained minimization problem and propose a numerical algorithm building on this result. The algorithm is implemented in a two-dimensional code and several examples are considered. It is found that the impact of the prepayment option on the loan value is not to be neglected and should be used to assess the risks related to client prepayment. Moreover, the Markov chain liquidity model is seen to describe more accurately clients' prepayment behavior than a model with constant liquidity.

Download Full-text

The prepayment option on mortgage securities: A random coefficient approach

Review of Quantitative Finance and Accounting ◽

10.1007/bf00243983 ◽

1992 ◽

Vol 2 (1) ◽

pp. 33-45 ◽

Cited By ~ 1

Author(s):

James B. Kau ◽

Thomas M. Springer

Keyword(s):

Random Coefficient ◽

Prepayment Option ◽

Mortgage Securities

Download Full-text

Valuing the Mortgage Borrower's Prepayment Option

Real Estate Economics ◽

10.1111/1540-6229.00352 ◽

1985 ◽

Vol 13 (3) ◽

pp. 229-247 ◽

Cited By ~ 34

Author(s):

Arden R. Hall

Keyword(s):

Prepayment Option

Download Full-text

The Principal Principle

Journal of Financial and Quantitative Analysis ◽

10.1017/s0022109012000506 ◽

2012 ◽

Vol 47 (6) ◽

pp. 1215-1246 ◽

Cited By ~ 10

Author(s):

Sanjiv R. Das

Keyword(s):

Interest Rate ◽

Adverse Selection ◽

Stochastic Interest Rate ◽

Principal Principle ◽

Present Value ◽

Ability To Pay ◽

Stochastic Interest ◽

Rate Environment ◽

Prepayment Option

AbstractI analyze optimal loan modification schemes in a stochastic home price and stochastic interest-rate environment. Lenders maximize loan values by managing the borrower’s option to default on the loan and prepayment option. Given negative equity, controlling for the borrower’s ability to pay, rate reductions and maturity extensions result in a higher probability of redefault by homeowners even after modification of their loans. In contrast, loan write-downs (the Principal Principle), not a favored recipe, are value maximizing for the lender. A shared-appreciation mortgage enhances the ability to pay, mitigates adverse selection, and reduces the present value of expected deadweight foreclosure costs.

Download Full-text

Valuation of the Prepayment Option of a Perpetual Corporate Loan

Abstract and Applied Analysis ◽

10.1155/2013/960789 ◽

2013 ◽

Vol 2013 ◽

pp. 1-13 ◽

Cited By ~ 1

Author(s):

Timothee Papin ◽

Gabriel Turinici

Keyword(s):

Credit Quality ◽

Default Intensity ◽

Liquidity Cost ◽

Funding Cost ◽

Liquidity Crisis ◽

Prepayment Option ◽

Cir Process ◽

Corporate Loan ◽

Cost Regime

We investigate in this paper a perpetual prepayment option related to a corporate loan. The default intensity of the firm is supposed to follow a CIR process. We assume that the contractual margin of the loan is defined by the credit quality of the borrower and the liquidity cost that reflects the funding cost of the bank. Two frameworks are discussed: firstly a loan margin without liquidity cost and secondly a multiregime framework with a liquidity cost dependent on the regime. The prepayment option needs specific attention as the payoff itself is an implicit function of the parameters of the problem and of the dynamics. In the unique regime case, we establish quasianalytic formulas for the payoff of the option; in both cases we give a verification result that allows for the computation of the price of the option. Numerical results that implement the findings are also presented and are completely consistent with the theory; it is seen that when liquidity parameters are very different (i.e., when a liquidity crisis occurs) in the high liquidity cost regime, the exercise domain may entirely disappear, meaning that it is not optimal for the borrower to prepay during such a liquidity crisis. The method allows for quantification and interpretation of these findings.

Download Full-text