Optimal Loan Interest Rate Contract Design

Robert Edelstein and Branko Urosevic

The Journal of Real Estate Finance and Economics, 2003, vol. 26, issue 2-3, 127-56

Abstract: This paper analyzes optimal loan interest rate contracts under conditions of risky, symmetric information for one-period (static) and multi-period (dynamic) models. The optimal loan interest rate depends upon the volatility of, and co-variation among the market interest rate, borrower collateral, and borrower income, as well as the time horizon and the risk preferences of lenders and borrowers. For a risk-averse borrower with stochastic collateral, variable interest rate contracts are, in general, Pareto optimal. For plausible assumptions, the optimal loan interest rate for the multi-period model often exhibits "muted" responses to changes in market interest rates, making fixed rate loans a reasonable approximation for the optimal loan. Hence, in the absence of optimal contracts, long-term (short-term) borrowers tend to prefer fixed rate (variable) contracts. Copyright 2003 by Kluwer Academic Publishers

Date: 2003
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