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Option value of credit lines as an explanation of high credit card rates

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  • Sangkyun Park
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    Abstract

    Credit lines offered by credit cards contain an option arising from changing default probabilities of cardholders. The option value can explain high credit card rates and high profits of card issuers. The card rate producing zero profit for card issuers is higher than interest rates on most other loans because rational cardholders borrow more money when they become riskier. Furthermore, cardholders borrowing when the option is out of the money may be less responsive to credit cared rates due to higher switching costs and carelessness. Card issuers, therefore, keep card rates at high levels that do not fully reflect the effect of out-of-the-money borrowing and make above-normal profits.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of New York in its series Research Paper with number 9702.

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    Date of creation: 1997
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    Handle: RePEc:fip:fednrp:9702

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    Related research

    Keywords: Credit cards ; Interest rates;

    References

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    1. Calem, Paul S & Mester, Loretta J, 1995. "Consumer Behavior and the Stickiness of Credit-Card Interest Rates," American Economic Review, American Economic Association, vol. 85(5), pages 1327-36, December.
    2. Boot, A.W.A. & Thakor, A.V. & Udell, G.F., 1987. "Competition, risk neutrality and loan commitments," Research Memorandum 260, Tilburg University, Faculty of Economics and Business Administration.
    3. Robert B. Avery & Allen N. Berger, 1988. "Loan commitments and bank risk exposure," Finance and Economics Discussion Series 36, Board of Governors of the Federal Reserve System (U.S.).
    4. Park, Sangkyun, 1997. "Effects of price competition in the credit card industry," Economics Letters, Elsevier, vol. 57(1), pages 79-85, November.
    5. Shaffer, Sherrill, 1999. "The Competitive Impact of Disclosure Requirements in the Credit Card Industry," Journal of Regulatory Economics, Springer, vol. 15(2), pages 183-98, March.
    6. Sangkyun Park, 1993. "The credit card industry: profitability and efficiency," Research Paper 9314, Federal Reserve Bank of New York.
    7. Brito, Dagobert L & Hartley, Peter R, 1995. "Consumer Rationality and Credit Cards," Journal of Political Economy, University of Chicago Press, vol. 103(2), pages 400-433, April.
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    Cited by:
    1. Sougata Kerr & Lucia Dunn & Stephen Cosslett, 2004. "Do Banks Use Private Information from Consumer Accounts? Evidence of Relationship Lending in Credit Card Interest Rate Heterogeneity," Working Papers 04-08, Ohio State University, Department of Economics.
    2. Shubhasis Dey, 2005. "Lines of Credit and Consumption Smoothing: The Choice between Credit Cards and Home Equity Lines of Credit," Working Papers 05-18, Bank of Canada.
    3. Lucia Dunn & Sougata Kerr, 2002. "Consumer Search Behavior in the Changing Credit Card Market," Working Papers 02-03, Ohio State University, Department of Economics.
    4. Shubhasis Dey & Gene Mumy, 2005. "Determinants of Borrowing Limits on Credit Cards," Working Papers 05-7, Bank of Canada.
    5. Ahmet Faruk Aysan & Nusret Ahmet Muslim, 2006. "The Failure of Competition in the Credit Card Market in Turkey: The New Empirical Evidence," Working Papers 2006/10, Turkish Economic Association.

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