Interest Rates and the Design of Financial Contracts

Michael Roberts () and Michael Schwert

No 27195, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We show that the partial response of loan rates to interest rate changes, referred to in the bank lending literature as “stickiness,” is a feature of perfect capital markets. No-arbitrage models of credit risk are able to replicate empirical interest rate sensitivities. However, the widespread use of interest rate floors in the low-rate environment of the last decade is a result of risk-sharing and incentive considerations arising from market imperfections. Floors reallocate cash flows across states in a way that loan spreads cannot. They insure lenders against losses if rates fall, while mitigating borrower moral hazard if rates rise.

JEL-codes: E44 G21 (search for similar items in EconPapers)
Date: 2020-05
New Economics Papers: this item is included in nep-ban, nep-cta and nep-mac
Note: CF
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