Prepayment option of a perpetual corporate loan: the impact of the funding costs
Papin, Timothée; Turinici, Gabriel (2014), Prepayment option of a perpetual corporate loan: the impact of the funding costs, International Journal of Theoretical and Applied Finance, 17, 4. http://dx.doi.org/10.1142/S0219024914500289
TypeArticle accepté pour publication ou publié
Journal nameInternational Journal of Theoretical and Applied Finance
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Abstract (EN)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 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.
Subjects / Keywordsloan prepayment; American option; prepayment option; funding costs; mortgage option; perpetual option; variational inequality; option pricing; CIR process; switching regimes; liquidity regime; Markov modulated dynamics
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