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

See all articles by Huamao Wang

Huamao Wang

University of Kent - Kent Business School

Zhaojun Yang

Southern University of Science and Technology - Department of Finance

Hai Zhang

Strathclyde Business School

Date Written: June 15, 2013

Abstract

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

Wang, Huamao and Yang, Zhaojun and Zhang, Hai, Entrepreneurial Finance with Equity-for-Guarantee Swap and Idiosyncratic Risk (June 15, 2013). 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., Available at SSRN: https://ssrn.com/abstract=2438929 or http://dx.doi.org/10.2139/ssrn.2438929

Huamao Wang

University of Kent - Kent Business School ( email )

Sibson Building
Canterbury, Kent CT2 7FS
United Kingdom

Zhaojun Yang (Contact Author)

Southern University of Science and Technology - Department of Finance ( email )

No 1088, Xueyuan Rd.
District of Nanshan
Shenzhen, Guangdong 518055
China

HOME PAGE: http://faculty.sustc.edu.cn/profiles/yangzj

Hai Zhang

Strathclyde Business School ( email )

199 Cathedral Street
Glasgow G4 0QU
United Kingdom

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