The Option Value of Non-Recourse Lending and Inflated Asset Prices

35 Pages Posted: 13 Mar 2002

See all articles by Andrey D. Pavlov

Andrey D. Pavlov

Simon Fraser University (SFU) - Finance Area

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate ; University of Pennsylvania - Finance Department

Date Written: February 2002

Abstract

We investigate the market prices of assets in fixed supply whose purchase is typically financed through non-recourse loans. The largest and most common asset in this category is real estate. We demonstrate the following two important features of such markets:

- Lenders' underpricing of the put option contained in the non-recourse loans leads to inflated asset prices within efficient markets, and - Under certain conditions, the presence of short-term players in the debt market induces all lenders to underprice the put option in equilibrium.

We further show that the probability of entering the "underpricing" equilibrium (i.e., all lenders underprice the put) increases with the time since the last negative demand shock, increases with the volatility of the asset market, and decreases with the size of the debt market. These results hold even when all participants in both equity and debt markets are fully rational. Furthermore, the model allows for management compensation that is aligned with maximizing bank shareholders' value. Using real estate transaction data we find strong empirical support for the predictions of the model.

JEL Classification: G12, G13, G21

Suggested Citation

Pavlov, Andrey D. and Wachter, Susan M., The Option Value of Non-Recourse Lending and Inflated Asset Prices (February 2002). Available at SSRN: https://ssrn.com/abstract=302939 or http://dx.doi.org/10.2139/ssrn.302939

Andrey D. Pavlov (Contact Author)

Simon Fraser University (SFU) - Finance Area ( email )

Burnaby, British Columbia V5A 1S6
Canada
604 291 5835 (Phone)
604 291 4920 (Fax)

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104-6330
United States
215-898-6355 (Phone)

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

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