Interest Rates and the Design of Financial Contracts

45 Pages Posted: 26 May 2020 Last revised: 21 Oct 2024

See all articles by Michael R. Roberts

Michael R. Roberts

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

Michael Schwert

AQR Arbitrage, LLC

Multiple version iconThere are 2 versions of this paper

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.

Suggested Citation

Roberts, Michael R. and Schwert, Michael, Interest Rates and the Design of Financial Contracts (May 2020). NBER Working Paper No. w27195, Available at SSRN: https://ssrn.com/abstract=3609647

Michael R. Roberts (Contact Author)

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

AQR Arbitrage, LLC ( email )

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