The Liquidity Regimes and the Prepayment Option of a Corporate Loan in the Finite Horizon Case

Abstract

We investigate the prepayment option related to a corporate loan. The default intensity of the firm is supposed to follow a Cox-Ingersoll-Ross (CIR) process and the short interest rate is assumed constant. A liquidity term that represents the funding costs of the bank is introduced and modeled as a continuous time discrete state Markov jump process. The prepayment option is an American option with the payoff being an implicit function of the parameters of the problem. We give a verification result that allows to compute the price of the option. Numerical results are completely consistent with the theory; it is seen that the exercise domain may entirely disappear during such a liquidity crisis meaning that it is not optimal for the borrower to prepay. The method allows to quantify and interpret these findings