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Call Options, Points, and Dominance Restrictions on Debt Contracts

Kenneth B. Dunn and Chester S. Spatt
The Journal of Finance
Vol. 54, No. 6 (Dec., 1999), pp. 2317-2337
Published by: Wiley for the American Finance Association
Stable URL: http://www.jstor.org/stable/797996
Page Count: 21
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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.

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