Bank lending linked to product market under swap hedging: an option-based optimization

This paper, explicitly incorporating characteristics of the borrower's product market, examines a financial claim for swap hedging. In an option-based model where loan markets are imperfectly competitive, changes in the hedging pricing and capital regulation have direct effects on the bank's optimal margin. An increase in the default probability of the commodity loan increases in the bank's market share in the loan market if the bank plays strategic substitutes and increases in the bank's margin if the bank plays strategic complements. This optimal margin is negatively related to the counterparty bank's loan rate or to the bank capital requirement when the bank realizes a relatively less risky state of the world or to the counterparty bank's default probability when the bank realizes a relatively more risky state. Our findings lead to an important implication that the link between the financial and product markets with swap hedging should be stronger.