An Analysis of Variable Rate Loan Contracts

Abstract

THE 1970s heralded times of rapid and intense inflation accompanied by high and volatile interest rates. While there have been many economic consequences attributable to these factors, perhaps most strongly affected have been the various markets and institutions dealing with fixed income securities. One reaction has been the introduction of variable rate loans. Floating rate corporate notes were first introduced in 1974 when a total of $1.3 billion were sold. Variable rate mortgages probably originated in the 1930s in the United Kingdom and Canada. Until recently they were restricted in this country. In these contracts the interest due is determined by currently prevailing rates and not the rates which were in force at the time of issuance. The purpose of this design is to stabilize the price or value of the contract-immunizing it against changes in interest rates. This paper presents a preliminary analysis of some aspects of variable rate loan contracts. Section II reviews a recently developed pricing model for the term structure of interest rates. Section III begins the discussion on variable rate loans by outlining the construction of various default-free contracts which offer perfect immunization. Section IV discusses some typical modifications found in existing variable rate contracts. In this section the price and risk of these modified contracts are determined in various examples. Finally Section V examines the changes required for variable rate contracts when there is the risk of default.