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
Language
English
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