Prepayment option of a perpetual corporate loan: the impact of funding costs

Timothée Papin (1) , Gabriel Turinici (1)

1 CEREMADE - CEntre de REcherches en MAthématiques de la DEcision

We investigate in this paper a perpetual prepayment option related to a corporate loan. The short interest rate and default intensity of the rm are supposed to follow CIR processes. A liquidity term that represents the funding costs of the bank is introduced and modeled as a continuous time discrete state Markov chain. The prepayment option needs speci c attention as the payo itself is a derivative product and thus an implicit function of the parameters of the problem and of the dynamics. We prove veri cation results that allows to certify the geometry of the exercise region and compute the price of the option. We show moreover that the price is the solution of a constrained minimization problem and propose a numerical algorithm building on this result. The algorithm is implemented in a two-dimensional code and several examples are considered. It is found that the impact of the prepayment option on the loan value is not to be neglected and should be used to assess the risks related to client prepayment. Moreover the Markov chain liquidity model is seen to describe more accurately clients' prepayment behavior than a model with constant liquidity.

Mots clés: Markov modulated dynamics; funding costs; liquidity regime; loan prepayment; mortgage option; American option; perpetual option; option pricing; variational inequality; prepayment option; CIR process; switching regimes; Markov modulated dynamics.

Domaines: Analyse numérique [math.NA]; Finance quantitative [q-fin.CP]; Gestion des risques [q-fin.RM]; Pricing [q-fin.PR]; Finance [q-fin.GN]; Economies et finances; Probabilités [math.PR]; Equations aux dérivées partielles [math.AP]

Timothée Papin, Gabriel Turinici. Prepayment option of a perpetual corporate loan: the impact of funding costs. 2012. ⟨hal-00768571v1⟩