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Valuation of the prepayment option of a perpetual corporate loan

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  • Turinici, Gabriel
  • Papin, Timothée
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    Abstract

    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. Two frameworks are discussed: first a constant interest rate and a secondly a multi-regime framework where the interest rate is augmented by a liquidity factor 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. We establish in the unique regime case analytic formulas for the payoff of the option; in both cases we give a verification result that allows to compute 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 occur) 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 to quantify and interpret these findings.

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    File URL: http://basepub.dauphine.fr/xmlui/bitstream/123456789/7818/2/papin_turinici_corporate_loans_AbstrApplAnal_2013.pdf
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    Bibliographic Info

    Paper provided by Paris Dauphine University in its series Economics Papers from University Paris Dauphine with number 123456789/7818.

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    Date of creation: 2013
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    Publication status: Published in Abstract and Applied Analysis, 2013, Vol. 2013
    Handle: RePEc:dau:papers:123456789/7818

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    Related research

    Keywords: Markov modulated dynamics; switching regimes; CIR process; prepayment option; Snell envelope; option pricing; perpetual option; American option; mortgage option; loan prepayment; liquidity regime;

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    1. Siu, Tak Kuen & Yang, Hailiang & Lau, John W., 2008. "Pricing currency options under two-factor Markov-modulated stochastic volatility models," Insurance: Mathematics and Economics, Elsevier, vol. 43(3), pages 295-302, December.
    2. Jimmy E. Hilliard & James B. Kau & V. Carlos Slawson, 1998. "Valuing Prepayment and Default in a Fixed-Rate Mortgage: A Bivariate Binomial Options Pricing Technique," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 26(3), pages 431-468.
    3. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
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    Cited by:
    1. Timothée Papin & Gabriel Turinici, 2014. "Prepayment option of a perpetual corporate loan: the impact of the funding costs," Post-Print hal-00768571, HAL.

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