Entrepreneurial Finance with Equity-for-Guarantee Swap and Idiosyncratic Risk
European Journal of Operational Research, Volume 241, Issue 3, 2015, Pages 863-871, ISSN 0377-2217, Doi.org/10.1016/j.ejor.2014.09.013.
29 Pages Posted: 20 May 2014 Last revised: 2 May 2019
Date Written: June 15, 2013
We consider a risk-averse entrepreneur who invests in a project with idiosyncratic risk and takes debt financing for diversification benefits. In contrast to the literature, we assume the entrepreneur is unable to get a loan from a bank directly because of the low creditability of the entrepreneur and lack of collateral and therefore, an innovative financial contract, named equity-for-guarantee swap, is signed among a bank, an insurer, and the entrepreneur. We build a dynamic incomplete model to investigate the effects of the swap on the entrepreneur's consumption, portfolio, financing and exit from the business. We find that the new swap leads to higher leverage, which brings more diversification and tax benefits. The new swap not only solves the serious problems of widespread financing constraints, but also significantly improves the welfare level of the entrepreneur. The growth of welfare level increases dramatically with risk-aversion index and the volatility of idiosyncratic risk.
Keywords: Borrowing Constraints, Equity-for-Guarantee Swap, Capital Structure, Cash-out Option
JEL Classification: G11, G31
Suggested Citation: Suggested Citation