When a bank makes a loan this is equivalent to the borrower issuing a bond. Many loans allow the borrower the option to repay its loan before term. This is equivalent to the borrower owning a call option. Many people complain when they decide to repay a loan early about the bank charging them a penalty fee. To them it seems grossly unfair. Penalty charges are completely understandable. The bank wishes to discourage early repayment and also has to be compensated for the value of the option it has written to the borrower.
The most obvious example of prepayment risks is that of fixed rate mortgages. These loans are long term and hence have long duration. When interest rates fall borrowers have a potential incentive to pay off their current loan and refinance it with a loan at the then prevailing lower interest rates. They are likely to do so when the savings from lower financing costs are greater than the costs of refinancing.
Posts Tagged ‘borrowers’
Callable bond equivalents
Monday, December 7th, 2009Refinancing risk
Tuesday, December 1st, 2009If the owners of bonds decide to sell the bond back to the issuer it is likely to be because interest rates have increased. (Another reason why bondholders might choose to put the bonds back is because they doubt the ability of the issuer to repay the principal at maturity.) The issuer is exposed to the risk that they will have to refinance the debt at a higher financing cost. The issuer is also exposed to the risk that it can not refinance the debt and will be unable to meet its obligations.
In this case the issuer of the bond has sold a put option to the buyer of the bond. The value of the underlying instrument will fall as interest rates rise increasing the value of the put option.
The duration to be used for assets and liabilities with embedded options has to be adjusted to take account of their presence. The duration then estimated is referred to as effective duration.