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Credit card pricing and impact of adverse selection

Credit card pricing and impact of adverse selection
Credit card pricing and impact of adverse selection
Variable pricing is one way of improving the profitability of credit cards when the price is the interest rate to be charged. However, choosing the appropriate price for each risk grade of default is not straightforward, as one of the main problems is adverse selection, when the lender finds that the borrowers who actually take a specific offer have a higher default rate than expected. We show that modelling the choice of credit card by the borrower as an auction process means that the winner's curse can lead to adverse selection. By modelling the way lenders use the credit score of a borrower in their pricing decision we are able to show that there is a simple relationship between the actual probability of a borrower repaying and what the successful lender believes this probability to be, regardless of the distribution of the errors caused by adverse selection. This allows one to assess the impact on profitability of these errors
credit card, auction model, variable pricing, adverse selection
0160-5682
1193-1201
Huang, Bo
d14fc43d-520a-4944-9897-13303670751c
Thomas, Lyn C.
a3ce3068-328b-4bce-889f-965b0b9d2362
Huang, Bo
d14fc43d-520a-4944-9897-13303670751c
Thomas, Lyn C.
a3ce3068-328b-4bce-889f-965b0b9d2362

Huang, Bo and Thomas, Lyn C. (2014) Credit card pricing and impact of adverse selection. Journal of the Operational Research Society, 65 (8), 1193-1201. (doi:10.1057/jors.2012.173).

Record type: Article

Abstract

Variable pricing is one way of improving the profitability of credit cards when the price is the interest rate to be charged. However, choosing the appropriate price for each risk grade of default is not straightforward, as one of the main problems is adverse selection, when the lender finds that the borrowers who actually take a specific offer have a higher default rate than expected. We show that modelling the choice of credit card by the borrower as an auction process means that the winner's curse can lead to adverse selection. By modelling the way lenders use the credit score of a borrower in their pricing decision we are able to show that there is a simple relationship between the actual probability of a borrower repaying and what the successful lender believes this probability to be, regardless of the distribution of the errors caused by adverse selection. This allows one to assess the impact on profitability of these errors

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pricing decisionrevisionsentJORSpaper.docx - Other
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More information

Accepted/In Press date: November 2012
e-pub ahead of print date: 19 June 2013
Published date: 2014
Keywords: credit card, auction model, variable pricing, adverse selection
Organisations: Centre of Excellence in Decision, Analytics & Risk Research

Identifiers

Local EPrints ID: 375180
URI: https://eprints.soton.ac.uk/id/eprint/375180
ISSN: 0160-5682
PURE UUID: 1a1cc659-f38b-468d-ba3e-189067252959

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Date deposited: 16 Mar 2015 11:55
Last modified: 17 Jul 2017 21:19

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