Real options: a commercial bank lending application

We extend existing real‐option theories by incorporating the stochastic interaction between unit price and cost, applied in commercial bank lending. We further empirically examine an implication derived from the model as to the relationship between lending practices in the banking industry and future uncertainties. We focus on lending institutions to analyze the effect of uncertainties on lending (investment) decisions for several reasons. First, it is easy to identify the main sources of uncertainties for the assets and liabilities of the financial institutions – default risk and interest rate changes. Second, the commercial lending institution provides a unique environment in which the correlation between investment costs (liabilities) and output (loans) price is quite high and positive since both depend heavily on interest rates. Finally, bank loans may be subject to a high degree of irreversibility (e.g., substantial loss in defaults). The real option model explains the relationship between levels of ...