Interest rate indexation and the pricing of loan commitment contracts

Abstract

The central question addressed in this paper is why most loan pricing agreements between banks and their commercial customers involve additive rather than multiplicative markups over the base lending rate. It is argued that banks generally prefer additive pricing because the real value of the premiums moves inversely with inflation. Therefore this pricing formula provides an automatic partial inflation hedge for banks. Most borrowers who hold long positions in nominal assets also prefer this formula for the same reason. However, some borrowers who hold net short positions in nominal assets prefer multiplicative pricing. Banks provide them with such a form of pricing in exchange for appropriate compensation. Supporting empirical evidence is provided.