Events

Professor Bo Sun
Associate Professor of Business Administration
Department of Economics
University of Virginia

We study the pervasive adoption of prepayment options in debt contracts, a phenomenon that persisted even during periods of near-zero interest rates when traditional hedging motives were attenuated. We develop an agency theoretic framework of debt contracting demonstrating that the option to prepay—representing opportunities to refinance when uncertainty about project quality abates over time—provides ex ante incentives for prudent risk-taking, thereby improving firm value. Leveraging the supervisory Federal Reserve Y-14Q data on individual loan contracts, we document data patterns on the take-up, pricing, and ex post perfor-mance of bank loans that are in line with a disciplining role of prepayment options.
These findings suggest that prepayment options may serve as a substitute for tradi-tional collateral-based lending by establishing dynamic state-contingent incentives that address moral hazard concerns. Moreover, we identify a strategic comple-mentarity between prepayment options and macroprudential regulation, whereby regulatory measures that enhance the risk sensitivity of loan pricing can amplify the disciplinary effect of prepayment options.