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

  • Sangkyun Park
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    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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    File URL: http://www.newyorkfed.org/research/staff_reports/research_papers/9702.html
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    File URL: http://www.newyorkfed.org/research/staff_reports/research_papers/9702.pdf
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    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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    1. Paul S. Calem & Loretta J. Mester, 1995. "Consumer behavior and the stickiness of credit card interest rates," Working Papers 95-10, Federal Reserve Bank of Philadelphia.
    2. Arnoud Boot & Anjan V. Thakor & Gregory F. Udell, 2004. "Competition, Risk Neutrality and Loan Commitments," Finance 0411051, EconWPA.
    3. Park, Sangkyun, 1997. "Effects of price competition in the credit card industry," Economics Letters, Elsevier, vol. 57(1), pages 79-85, November.
    4. 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.
    5. Sangkyun Park, 1993. "The credit card industry: profitability and efficiency," Research Paper 9314, Federal Reserve Bank of New York.
    6. Robert B. Avery & Allen N. Berger, 1989. "Loan commitments and bank risk exposure," Finance and Economics Discussion Series 65, Board of Governors of the Federal Reserve System (U.S.).
    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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