Interest Rates and the Design of Financial Contracts
45 Pages Posted: 26 May 2020 Last revised: 21 Oct 2024
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Interest Rates and the Design of Financial Contracts
Date Written: May 2020
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.
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