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

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  • Sangkyun Park

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.

Suggested Citation

  • Sangkyun Park, 1997. "Option value of credit lines as an explanation of high credit card rates," Research Paper 9702, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednrp:9702
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    References listed on IDEAS

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    1. Boot, Arnoud & Thakor, Anjan V. & Udell, Gregory F., 1987. "Competition, risk neutrality and loan commitments," Journal of Banking & Finance, Elsevier, vol. 11(3), pages 449-471, September.
    2. 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.
    3. Avery, Robert B. & Berger, Allen N., 1991. "Loan commitments and bank risk exposure," Journal of Banking & Finance, Elsevier, vol. 15(1), pages 173-192, February.
    4. Park, Sangkyun, 1997. "Effects of price competition in the credit card industry," Economics Letters, Elsevier, vol. 57(1), pages 79-85, November.
    5. 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 1327-1336, December.
    6. Shaffer, Sherrill, 1999. "The Competitive Impact of Disclosure Requirements in the Credit Card Industry," Journal of Regulatory Economics, Springer, vol. 15(2), pages 183-198, March.
    7. Sangkyun Park, 1993. "The credit card industry: profitability and efficiency," Research Paper 9314, Federal Reserve Bank of New York.
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    Cited by:

    1. 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.
    2. Shubhasis Dey & Gene Mumy, 2005. "Determinants of Borrowing Limits on Credit Cards," Staff Working Papers 05-7, Bank of Canada.
    3. 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.
    4. Shubhasis Dey, 2005. "Lines of Credit and Consumption Smoothing: The Choice between Credit Cards and Home Equity Lines of Credit," Staff Working Papers 05-18, Bank of Canada.
    5. Kerr, Sougata & Dunn, Lucia, 2008. "Consumer Search Behavior in the Changing Credit Card Market," Journal of Business & Economic Statistics, American Statistical Association, vol. 26, pages 345-353.

    More about this item

    Keywords

    Credit cards ; Interest rates;

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