max [0, R - B(1 + rb)] ,
where R is the total value of the investment in period 2.
The lender’s position given the default option for the borrower above can also be
The payoff structure to the lender is thus presented in the form of a put option. The debt
contract gives the borrower the right to sell the project to the lender for the borrowed
amount B, should outcomes be poor. The lender, as the seller of the put option, does not
have a choice. From the lender’s perspective, the payoff Rl can be represented as:
- B ≤ Rl ≤ rbB.
These incentives illustrate the difficulties that risk creates for efficient functioning
of credit markets. Institutions have developed to ameliorate some risks in credit
provision. For example, contract terms exist in credit markets to mitigate this clear
incentive for borrowers to default. These contract terms include:
11
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