Interest Rates and the Design of Financial Contracts

44 Pages Posted: 13 Jan 2020 Last revised: 21 Jan 2022

See all articles by Michael R. Roberts

Michael R. Roberts

The Wharton School - University of Pennsylvania; National Bureau of Economic Research (NBER)

Michael Schwert

University of Pennsylvania - The Wharton School

Multiple version iconThere are 2 versions of this paper

Date Written: January 14, 2022

Abstract

We show that the partial response of loan rates to interest rate changes, referred to in the bank lending literature as ``stickiness,'' is a feature of perfect capital markets. No-arbitrage models of credit risk are able to replicate empirical interest rate sensitivities. However, the widespread use of interest rate floors in the low-rate environment of the last decade is a result of risk-sharing and incentive considerations arising from market imperfections. Floors reallocate cash flows across states in a way that loan spreads cannot. They insure lenders against losses if rates fall, while mitigating borrower moral hazard if rates rise.

Keywords: financial contracts, interest rates, banking, commercial lending

JEL Classification: G21, G23, E43, E52

Suggested Citation

Roberts, Michael R. and Schwert, Michael, Interest Rates and the Design of Financial Contracts (January 14, 2022). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper , Available at SSRN: https://ssrn.com/abstract=3508816 or http://dx.doi.org/10.2139/ssrn.3508816

Michael R. Roberts

The Wharton School - University of Pennsylvania; National Bureau of Economic Research (NBER) ( email )

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HOME PAGE: http://finance.wharton.upenn.edu/~mrrobert/

Michael Schwert (Contact Author)

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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