Stock loans in incomplete markets

TL;DR

This paper extends the valuation of stock loans to incomplete markets, accounting for trading restrictions, and provides analytical and numerical insights into how loan fees vary with model parameters.

Contribution

It introduces a new valuation framework for stock loans in incomplete markets, deriving exact and variational inequality-based formulas for loan fees.

Findings

Exact formula for infinite maturity loan fee.

Characterization of finite maturity loan fee via variational inequalities.

Numerical illustration of fee dependence on model parameters.

Abstract

A stock loan is a contract whereby a stockholder uses shares as collateral to borrow money from a bank or financial institution. In Xia and Zhou (2007), this contract is modeled as a perpetual American option with a time varying strike and analyzed in detail within a risk--neutral framework. In this paper, we extend the valuation of such loans to an incomplete market setting, which takes into account the natural trading restrictions faced by the client. When the maturity of the loan is infinite, we use a time--homogeneous utility maximization problem to obtain an exact formula for the value of the loan fee to be charged by the bank. For loans of finite maturity, we characterize the fee using variational inequality techniques. In both cases we show analytically how the fee varies with the model parameters and illustrate the results numerically.