Call Options, Points, and Dominance Restrictions on Debt Contracts

Abstract

We analyze the impact of a contract's length, callability, amortization, and original discount by arbitrage methods. Among instruments that are callable without penalty, longer instruments command a higher interest rate because the borrower possesses the option of repaying relatively more slowly. However, the rate on longer self-amortizing loans cannot be substantially larger than for shorter ones because the payments decrease with contract length. Bounds on the trade-off between points and rate for callable debt are characterized using the trade-off for noncallable debt and the property that the value of the prepayment option increases with the loan's interest rate.