Option Value of Credit Lines as an Explanation of High Credit Card Rates

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Research Papers

Option Value of Credit Lines as an Explanation of High Credit Card Rates

February 1997 Number 9702

JEL classification: D40, D80, G12

Author: Sangkyun Park

Credit lines offered by credit cards contain an option arising from changing default probabilities of cardholders. The option value can explain high credit card rates and high profits of cardissuers. The card rate producting zero profit for cardissuers is higher than interest rates on most other loans because rational cardholders borrow more money when they become riskier. Furthermore, cardholders borrowing when the option is out of the money may be less responsive to credit cared rates due to higher switching costs and carelessness. Cardissuers, therefore, keep card rates at high levels that do not fully reflect the effect of out-of-the-money borrowing and make above-normal profits.

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