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Bo Sun

University of Virginia

Prepayment Option and Firm Risk-taking

Date: Friday, May 2, 2025
Time: 10:30-11:45 am
Location: Bronfman Bldg. (1001 Sherbrooke St. West), Room 245

All are cordially invited to attend.

Abstract:

The prepayment option has been a pervasive feature of debt contacting, even during periods of effectively zero interest rates when demand for interest-rate hedging was limited, and has been linked to varying penalties depending on the type of debt. Why is prepayment widely used in debt contracts? Why is prepayment associated with differential penalties across types of debt? We explore these questions in an agency theoretic framework of debt contracting. The option to prepay—representing opportunities to refinance at a favorable rate when information friction subsides over time—provides ex ante incentives for prudent risk-taking, thereby improving firm value. We rationalize prepayment penalty as a contracting device to deter inefficient prepayment. Leveraging the supervisory Federal Reserve Y-14Q data on individual loan contracts, we document data patterns on the take-up, pricing, and ex post performance of bank loans that are consistent with the incentivizing mechanism of prepayment options.