Consumer rationality and credit card pricing: An explanation based on the option value of credit lines

An option is embedded in credit cards. Since credit cards offer open credit lines, cardholders can borrow at the same terms when they become riskier. This option value raises the zero-profit card rate. Furthermore, adverse selection occurs if cardholders are better informed about the probability of becoming riskier in the future and borrow more when they become riskier. The adverse selection can limit rate competition and keep the card rate above the zero-profit card rate. An up-front fee is not a good alternative because it is also vulnerable to adverse selection. A low introductory card rate is an effective way to avoid the adverse selection problem when asymmetric information is mainly about the change in the borrower's risk profile in the future, as opposed to the riskiness in the present period. Copyright © 2004 John Wiley & Sons, Ltd.