The Liquidity Regimes and the Prepayment Option of a Corporate Loan in the Finite Horizon Case

Timothee Papin and Gabriel Turinici ()
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Timothee Papin: CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - Université Paris Dauphine-PSL - PSL - Université Paris Sciences et Lettres - CNRS - Centre National de la Recherche Scientifique, BNP Paribas CIB Ressource Portfolio Management
Gabriel Turinici: IUF - Institut universitaire de France - M.E.N.E.S.R. - Ministère de l'Education nationale, de l’Enseignement supérieur et de la Recherche, CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - Université Paris Dauphine-PSL - PSL - Université Paris Sciences et Lettres - CNRS - Centre National de la Recherche Scientifique

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Abstract: We investigate the prepayment option related to a corporate loan. The default intensity of the firm is supposed to follow a Cox-Ingersoll-Ross (CIR) process and the short interest rate is assumed constant. A liquidity term that represents the funding costs of the bank is introduced and modeled as a continuous time discrete state Markov jump process. The prepayment option is an American option with the payoff being an implicit function of the parameters of the problem. We give a verification result that allows to compute the price of the option. Numerical results are completely consistent with the theory; it is seen that the exercise domain may entirely disappear during such a liquidity crisis meaning that it is not optimal for the borrower to prepay. The method allows to quantify and interpret these findings.

Keywords: liquidity regime; loan prepayment; mortgage option; American option; option pricing; prepayment option; CIR process; switching regimes; Markov modulated dynamics (search for similar items in EconPapers)
Date: 2015
Note: View the original document on HAL open archive server: https://hal.science/hal-01073598v2
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Published in Global Credit Review, 2015, 5 (1), pp.19-33. ⟨10.1142/S2010493615500026⟩

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-01073598

DOI: 10.1142/S2010493615500026

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