| The Journal of Real Estate Finance and Economics | |
| Volume 26, Issue 2, Article 1 (Abstract) | |
| Title: | Optimal Loan Interest Rate Contract Design |
| Author: | Robert H. Edelstein and Branko Urosevic |
| Abstract: | This paper analyzes optimal loan interest rate contracts under conditions of risky, symmetric information for one-period (static) and multi-period (dynamic) models. The optimal loan interest rate depends upon the volatility of, and co-variation among the market interest rate, borrower collateral, and borrower income, as well as the time horizon and the risk preferences of lenders and borrowers. For a risk-averse borrower with stochastic collateral, variable interest rate contracts are, in general, Pareto optimal. For plausible assumptions, the optimal loan interest rate for the multi-period model often exhibits "muted" responses to changes in market interst rates, making fixed rate loans a reasonable approxmation for the optimal loan. Hence, in the absence of optimal contracts, long-term (short-term) borrowers tend to prefer variable fixed rate contracts. |
| Keywords: | optimal loan contracts, adjustable interest rate loans, lending and borrowing under risk, credit rationing, credit availability |