Title

Pricing of loan commitments for facilitating stochastic liquidity needs

Document Type

Journal article

Source Publication

Journal of Financial Services Research

Publication Date

1-1-2011

Volume

39

Issue

1-2

First Page

71

Last Page

94

Keywords

Bank liquidity reserve holding, Liquidity needs, Pricing of bank loan commitments

Abstract

A bank loan commitment is often priced as a European-style put option that is used by a company with a known borrowing need on a known future date to lock in an interest rate. The literature has abstracted some of the important institutional features of a loan commitment contract. First, the timing, number, and size of the loan takedowns under such a contract are often random, rather than fixed. Second, companies often use loan commitment contracts to reduce the transaction costs of frequent borrowing and to serve as a guarantee for large and immediate random liquidity needs. Third, commercial banks maintain liquidity reserves for making random spot loans or random committed loans. Partial loan takedowns raise, rather than lower, the opportunity cost of a committed bank's holding of excess capacity. This paper introduces a "stochastic needs-based" pricing model that incorporates these features. Simulations are conducted to illustrate the effects of various parameters on the fair price of a loan commitment.

DOI

10.1007/s10693-010-0083-6

Print ISSN

09208550

Funding Information

Financial support from the University Research Grants and the Academic Programme Research Grants of Lingnan University.

Publisher Statement

Copyright © 2010 Springer Science+Business Media, LLC. Access to external full text or publisher's version may require subscription.

Full-text Version

Publisher’s Version

Recommended Citation

Hau, A. (2011). Pricing of loan commitments for facilitating stochastic liquidity needs. Journal of Financial Services Research, 39(1-2), 71-94. doi:10.1007/s10693-010-0083-6

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