Derivatives and Usury: The Role of Options in Transactions Used to Act in Fraud of the Law
11 Pages Posted: 2 Nov 2015
Date Written: May 17, 2015
The search for derivative contracts with complex features can also be explained as the market’s attempt to elude the restrictions imposed by the law on money loans. This is an undesirable effect of anti-usury rules. It can be added to the one mentioned by Montesquieu and Adam Smith, who pointed out that usury increases with the severity of the prohibition, since the lender indemnifies himself for the risk he runs of suffering the penalty.
In this paper we look at some of the ways in which derivative contracts can be used to circumvent anti-usury provisions and conceal money loans made at exorbitant rates.
After examining the simplest cases, we will consider more complex contracts, such as swaps with embedded options, which are often used in dealings between banks and municipalities. Our thesis is that, in all these cases, in order to detect usury, we have to calculate the contracts’ option-adjusted yields.
Keywords: put-call parity, forwards, box spreads, strangles, interest-rate swaps, collars, caps, floors, flat volatility, spot volatility
JEL Classification: G14
Suggested Citation: Suggested Citation