Optimal prepayment behaviour

Abstract

Commercial loan borrowers meet random cash needs via multi-period loans from the bank, but fluctuations in interest rates may justify paying off some outstanding loans before they mature. The objective is to minimize the expected present value of the interest and prepayment penalties paid to the bank subject to a liquidity constraint. From Chiang (2005), it is shown that a firm should not inventory cash if contingent opportunities are ignored. By extending her article, it is also found that if a borrower is not risk neutral, a more risk-averse borrower prepays a larger amount.

Acknowledgements

The author would like to thank Dr Matthew J. Sobel for his kind suggestions and comments.