What Your Borrowers Hold

Pricing the options embedded in every loan — prepayment, drawdown, caps, floors, and rate locks are not fine print; they are financial instruments the bank has sold and must recover in the rate it charges

Every loan contract hands the borrower at least one right the bank cannot refuse. A mortgage borrower can prepay — refinancing when rates fall, leaving the bank holding an asset that reprices downward at exactly the wrong moment. A corporate with a committed facility can draw the full line in a crisis, forcing the bank to fund the drawdown on the worst possible day. A floating-rate borrower with a contractual cap gets free insurance against rate spikes. These are options — real, valuable, and almost always given away for free, buried in the fine print. If the bank does not price them, it is selling financial instruments below cost and calling it lending.

How much do these hidden instruments cost? Consider Avelmont's loan book on any given day. A ten-year fixed-rate mortgage carries roughly 20 basis points of prepayment optionality. A five-year committed revolver carries 37 basis points of drawdown and related option cost. A capped floating-rate term loan can embed 53 basis points of option value. Same bank, same afternoon — completely different option profiles, none of which appears on the term sheet as a line item, all of which erode margin if left unpriced.

The question is not whether the borrower holds these options. The contract already says they do. The question is whether the bank knows what it gave away — and whether it charges enough to get it back.

Two Families of Embedded Options

Not all embedded options behave the same way, and the distinction matters for pricing. The options in a loan contract fall into two families, and confusing the two leads to the wrong model, the wrong price, and the wrong hedge.

Behavioral options

These depend on a human decision. The borrower chooses whether and when to exercise. Prepayment is behavioral — the borrower decides to refinance, sell the property, or pay down the balance. Drawdown on a committed facility is behavioral — the corporate treasurer decides to pull the line. The exercise decision is influenced by rates, credit conditions, personal circumstances, and plain inertia, which means the option's value cannot be computed from a formula alone. It requires a model of human behavior, and human behavior is messy.

A borrower who "should" prepay — rates fell 200 basis points, the refinancing gain is obvious — might not, because of transaction costs, paperwork friction, or credit deterioration that blocks a new loan. A borrower who "shouldn't" prepay — rates rose, prepayment destroys value — sometimes does anyway, for reasons that have nothing to do with rates: a job relocation, a business sale, a divorce settlement. The prepayment model must capture this asymmetry between rational incentive and actual behavior, or it will misprice the option in both directions.

Automatic options

These are contractual, triggered by a formula, not by a decision. Caps and floors are automatic — they kick in whenever the floating rate crosses the strike, regardless of anyone's choice. No behavioral model is needed. Exercise is binary and determined by one observable number: the reference rate on the reset date. Pricing is clean, market-standard, and can be done with closed-form formulas that any derivatives desk would recognize.

The practical consequence: behavioral options are harder to price, harder to hedge, and more dangerous to ignore. Automatic options are easier to price but often larger in magnitude, because the contractual protection they provide is unconditional.

Prepayment as a Receiver Swaption

When a borrower prepays a fixed-rate loan, what exactly happens? The borrower had been paying a fixed rate — say 5.50% — on a remaining balance with several years left to run. Rates have since fallen to 4.00%. By prepaying the old loan and refinancing at the new rate, the borrower replaces an above-market fixed obligation with a lower one. The borrower has, in effect, exercised the right to receive the old fixed rate (by cancelling the obligation) and pay the new, lower market rate (by entering a new loan).

This is economically equivalent to exercising a receiver swaption — the right to receive fixed and pay floating. The bank originated the loan and, in doing so, sold this swaption to the borrower. It was given away at closing, bundled into the contract, never priced as a separate instrument. The bank is short the swaption. The borrower holds it. And its value grows every time rates fall.

How much is this short swaption position worth? It depends on three things: how far rates might fall (the swaption's moneyness), how long the loan has left to run (the swaption's tenor), and how likely the borrower is to exercise (the conditional prepayment rate, or CPR). The first two are standard derivatives inputs. The third is the behavioral wrinkle that makes loan prepayment harder than anything on a derivatives desk.

The asymmetric CPR

The CPR is not a constant. It is not even symmetric. It bends sharply upward when rates fall — borrowers rush to refinance when the rate incentive is large enough to justify the transaction costs — and barely moves when rates rise. Almost no one prepays into a higher rate. When they do, it is for non-rate reasons: selling the house, closing the business, settling an estate. This asymmetry is the single most important feature of prepayment modeling, and any model that treats prepayment as a flat annual rate — say, 8% per year regardless of where rates are — will dramatically underprice the option.

Why? Because a flat CPR averages the high-exercise states (rates fell, borrowers prepay aggressively, bank loses) with the low-exercise states (rates rose, borrowers stay put, bank is fine). The averaging washes out the asymmetry, and the asymmetry is where all the cost lives. The option is expensive precisely because it pays off in bad states for the bank. A symmetric model hides this.

The Three-Move Decomposition of Prepayment Cost

Knowing that prepayment is an option is not enough. The bank needs a number — how many basis points should the rate include to compensate for the prepayment right? Avelmont's pricing desk decomposes the answer into three moves.

Move 1: Model the CPR as a function of the rate incentive

The conditional prepayment rate is not a single number. It is a function of how far the current market rate sits below the loan's fixed rate — the rate incentive. When the incentive is zero or negative (rates are flat or higher), the CPR hovers near a base level, perhaps 3–5%, reflecting non-rate prepayments: relocations, business events, deaths. When rates fall 100 to 200 basis points below the loan rate, the CPR climbs steeply — borrowers start refinancing in earnest. Beyond 200 basis points, the curve flattens: most borrowers who can refinance already have; the remainder are blocked by credit issues, small balances, or sheer inertia. The curve is S-shaped, and the shape matters more than any single point on it.

Move 2: Survival

Each year, the borrowers who have not yet prepaid are the survivors. The pool shrinks over time. If 15% of the pool prepays in year one, only 85% remains to prepay in year two. If another 12% of that remainder prepays in year two, the surviving pool entering year three is 75%. This compounding survival matters because early prepayment costs the bank more — more remaining cash flows are lost when a borrower exits in year one than in year four. Late prepayment costs less, because fewer future cash flows remain to be forfeited.

Move 3: Value each year as a swaption on the remaining cash flows

At each year along the loan's life, the prepayment option is a swaption on whatever cash flows remain from that point forward. Year one's swaption covers four remaining years of cash flow. Year five's swaption covers only the final year. The swaption value per year depends on the product of two forces: the survival probability (how much of the pool is still alive to prepay) and the swaption's intrinsic value (which grows with the remaining tenor).

For Avelmont's five-year fixed-rate loan, the year-by-year strip comes out as follows: year 1 = 7 bps, year 2 = 9 bps, year 3 = 8 bps, year 4 = 6 bps, year 5 = 3 bps. Total: roughly 33 basis points. The cost peaks in the middle of the loan's life, not at the beginning or the end, because early years have high survival but a short remaining swaption, while late years have a long swaption but low survival. The product of the two peaks in the middle.

Drawdown as Readiness Cost

A committed credit facility gives the borrower the right to draw at any time, up to the limit, for any reason. The bank cannot say no. It cannot delay. It cannot reprice the draw at a wider spread. The commitment is a guarantee of access to funding on predetermined terms, and guarantees are never free.

What does it cost the bank to stand behind this guarantee? The cost has two parts, and neither is trivial.

The first is the buffer carry. The bank must hold or arrange liquidity against the undrawn commitment — liquid assets in the treasury portfolio, committed backup lines from other banks, or reserved borrowing capacity at the central bank. This buffer earns less than the bank's cost of funding it, and the difference is a carry cost that runs every day the line remains undrawn. It is the cost of readiness.

The second is the spread risk. When the borrower finally draws, the bank must fund the drawdown at whatever spread prevails in the wholesale market at that moment. If the draw happens on a calm Tuesday in March, the funding spread might be modest. If it happens during a liquidity crisis — and this is the problem — the funding spread will be wide, possibly very wide, and the bank is locked into lending at the contractual rate regardless.

Here is the wrong-way risk that makes drawdown so expensive: borrowers draw precisely when the bank least wants to fund. A corporate with a healthy cash flow and easy access to the bond market does not draw its revolver. A corporate whose bond market access has evaporated, whose receivables are stretching, whose rating is under review — that corporate draws the revolver, fully, immediately, on the worst possible day. Drawdown correlates with stress. The correlation amplifies the cost beyond what any naive average would suggest.

For Avelmont's $100 million revolver with $60 million undrawn, the drawdown option alone prices at 25–35 basis points — dwarfing the prepayment cost on a similarly sized term loan. The readiness cost is the dominant embedded option in any committed facility.

Caps and Floors — the Automatic Options

A floating-rate loan with a 6% cap gives the borrower something unambiguous: if the reference rate exceeds 6%, the bank absorbs the excess. The borrower's effective rate is capped at 6% plus the credit spread, no matter how high the benchmark climbs. This is not a behavioral feature. There is no decision to exercise. The cap kicks in automatically, contractually, the moment the reference rate crosses the strike on any reset date.

What is the bank's exposure? It is short a strip of caplets — one at each reset date over the loan's life. Each caplet has the same strike (6%), each references the forward rate for that period, and each can be priced using the Black formula for interest rate options. No CPR model, no behavioral assumptions, no guesswork about borrower rationality. The inputs are the forward curve, the cap volatility surface, and the day-count conventions. The pricing is clean and market-standard, indistinguishable from what a derivatives desk would compute for an identical standalone cap.

For Avelmont's five-year quarterly-reset floating-rate loan with a 6% cap, the cost of the embedded cap works out to roughly 48 basis points amortized over the loan's life. That is 48 basis points the bank must recover in the lending spread, or it is giving away free insurance and booking the premium as a hidden loss.

Floors work in the same direction but protect the bank. A floor at 2% means the borrower's reference rate never falls below 2%, even if the benchmark drops to zero. This limits the borrower's benefit when rates decline and provides the bank with a minimum yield. A floor is a strip of floorlets, each a put on the forward rate, each priced with the same Black framework. When a loan includes both a cap and a floor, the borrower has bought a cap and sold a floor — the net cost depends on the relative strikes, the level of rates, and the shape of the volatility surface.

Pipeline Risk — the Dual Option

Between commitment and funding, a gap opens. The bank has promised a rate — the rate lock — but the borrower has not yet drawn. During this gap, which can last weeks or months, the borrower holds a peculiar two-sided option that the bank cannot escape.

If rates fall, the borrower funds. The rate lock is now above market, and the borrower locks in a favorable deal. The bank, having hedged or not, absorbs the rate move on the commitment it must honor. If rates rise, the borrower may walk away. The deal falls through, the bank loses the origination effort, and whatever hedge it put in place now needs to be unwound at a loss or carried as a naked position.

This is a dual option: the bank is short a call (the borrower funds when rates fall) and short a put (the borrower walks when rates rise). Or more precisely, it is a straddle-like exposure whose asymmetry depends on the fallout model — how many borrowers walk at each level of rate increase — and on whatever hedge the bank has put in place during the lock period.

Pipeline risk is short-lived. A single rate lock might last 45 to 90 days. But in aggregate, the exposure can be enormous. A mortgage lender with $500 million in outstanding rate locks holds an option book of significant size, and the Greeks on that book — delta, gamma, vega — shift with every basis point the market moves. Managing pipeline risk is, in every meaningful sense, running a derivatives book, whether the bank calls it that or not.

The Optionality Stack Across Products

The most revealing exercise is to line up three different products from the same bank on the same day and compare their embedded option profiles. The numbers tell a story about which rights dominate which contracts.

Same bank, same day — completely different option profiles. The mortgage is dominated by prepayment risk: the borrower's right to refinance when rates fall is almost the entire embedded cost. The revolver is dominated by drawdown readiness: the commitment to fund on demand, especially in stress, is the expensive part. The capped floater is dominated by the cap itself: the contractual insurance against rate spikes dwarfs everything else.

What determines which option dominates? The product's embedded rights. A fixed-rate product naturally embeds prepayment optionality. A committed facility naturally embeds drawdown optionality. A capped product naturally embeds cap optionality. The product design determines the option profile, and the option profile determines where the pricing risk concentrates.

Completing the Price

The options are already in the contract. The borrower holds them whether you price them or not. A mortgage borrower holds a receiver swaption. A corporate with a committed facility holds a funding guarantee. A borrower with a capped rate holds a strip of caplets. A borrower in a rate-lock period holds a straddle-like position against the bank. None of these rights are free. All of them have real, computable value. And all of them are exercised, sooner or later, in the states of the world where the cost to the bank is highest.

The only question is whether the bank recovers their cost in the rate it charges — or discovers the cost in the P&L, after the borrower exercises, when it is too late to adjust. A mortgage portfolio that ignores prepayment optionality will show mysterious margin compression every time rates fall. A revolver book that ignores drawdown cost will bleed during every funding stress. A floating-rate book with unpriced caps will produce losses that look like bad luck but are actually unbooked option premiums showing up as realized claims.

Prepayment, drawdown, caps, floors, rate locks — each is a real option with real value. Naming them, measuring them, and charging for them is not overcomplicating the price. It is completing it. The bank that does not price its embedded options has not simplified its lending business. It has simply decided to discover the cost later, in the worst possible way, on the worst possible day.