Efficient Contracts in Credit Markets Subject to Interest Rate Risk: An Application of Raviv's Insurance Model.

The article highlights that the interest rate risk borne by financial institutions has increased markedly as the credit markets have become unstable in recent years. The burden of this new instability has been especially severe for lending institutions whose balance sheets show the greatest mismatch between the maturities of assets and liabilities. The savings and loan industry, for example, which borrows short and lends long, suffered serious losses in recent years as income from its portfolio of old mortgages failed to keep pace with the escalating cost of short-term funds. The specter of such losses has led to the emergence of adjustable rate mortgages (ARM) as well as other types of variable rate contracts. These contracts often specify a complex functional relationship between the future loan interest rate and the lender's future cost of funds. In view of the growing popularity of variable-rate loans, the article discusses various aspects of the optimal variable-rate contract, focusing especially on the contractual relationship between the loan rate and the future cost of funds with reference to model of economist Artur Raviv.