The Student Loan Consolidation Option

The consolidation option is an exotic financial derivative, created by a few paragraphs in the Higher Education Act. It allows students to convert their floating rate loans to a fixed rate equal to the average floating rate on their outstanding loans. In this study we develop an options pricing model to estimate of the cost of the consolidation option, and to evaluate the sensitivity of that cost to changes in rules and economic conditions. The model takes into account borrower behavior, program rules, the stochastic properties of interest rates, default, and the market price of risk. The analysis implies that between 1998 and 2005, the option had an ex post cumulative cost to the government of about $27 billion. We argue that the subsidy is highly inefficient. Its incidence has been largely random, conferring the greatest benefit on those cohorts who happened to graduate when interest rate conditions were most favorable. It also differentially benefited professional students with the largest loan balances, and those with the sophistication to efficiently manage their loans. Since most entering students are likely to be unaware of the option