The Student Loan Consolidation Option: An Analysis of an Exotic Financial Derivative: Working Paper 2007-05
The federal government makes subsidized federal financing for higher education widely available. The extent of the subsidy varies over time with interest rate and credit market conditions. A loan provision that adds considerably to the size and volatility of the subsidy is the consolidation option, which allows students to convert floating-rate federal loans to a fixed rate equal to the average floating rate on their outstanding loans. We develop a model to estimate the option’s cost and to evaluate its sensitivity to changes in program rules, economic conditions, and borrower behavior. We
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