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Abstract: We develop a rational-expectations competitive equilibrium model to explore the pricing mechanism of a rent-to-own agreement. It accounts for the agreement’s unique features such as the return or early purchase options and several free services included in the contract.
Using detailed transactional data, we infer how customers exercise these options to calibrate our model for several product categories, contractual lengths and payment periodicity. In all cases, our model is able to match the patterns displayed by the observed markups and APRs very well; however, it falls a little short in matching the levels.
[Keywords: embedded options, financial distress, subprime industry]