Real Option Signaling Games of Debt Financing Using Equity Guarantee Swaps

Wang, Q. and Kwok, Y. K. (2020). Real option signaling games of debt financing using equity guarantee swaps. International Journal of Theoretical and Applied Finance, 23(5), 2050036.

35 Pages Posted: 30 Aug 2019 Last revised: 10 Jan 2022

See all articles by Qiuqi Wang

Qiuqi Wang

University of Waterloo - Department of Statistics and Actuarial Science

Yue Kuen Kwok

Hong Kong University of Science & Technology - Department of Mathematics

Date Written: July 13, 2019

Abstract

We analyze the real option signaling game models of debt financing of a risky project under information asymmetry, where the firm quality is only known to the firm management but not outsiders. The firm decides on the optimal investment timing of the risky project that requires upfront fixed funding cost and subsequent operating costs. The fixed funding cost is financed via either direct bank loan or entering into a three-party equity guarantee swap (EGS) that involves a bank granting the loan and third party guarantor. Under the EGS agreement, the guarantor is obligated to pay all the future coupon stream to the bank upon default of the firm. In return for the provision of the guarantee, the guarantor obtains certain proportional share of equity of the firm at the time when the swap agreement is signed. The share of equity demanded by the guarantor depends on the outside investors' belief on the firm quality. The low-type firm has the incentive to mimic the investment strategy of being high-type in terms of investment timing and share of equity. The high-type firm may adopt the appropriate separating strategy by speeding up investment or choosing an alternative financing choice. The resulting loss of the real option value of the investment opportunity represents the information cost under separating strategies. We examine the incentive compatibility constraints faced by the firm under different quality types and discuss characterization of the separating and pooling equilibriums. Unlike the usual assumption of perpetuity of investment opportunity, our real option model assumes the time window of the investment opportunity to be finite. We explore how the information cost and nature of separating and pooling equilibriums evolves over the finite time span of the investment opportunity. The information costs and investment thresholds exhibit interesting time dependent behaviors. We examine the firm's investment and financing choice between EGS and the direct bank loan against time and other parameters via comparison of the corresponding information costs and investment thresholds.

Keywords: debt financing, signaling games, separating and pooling equilibriums, real options, information costs

JEL Classification: G31, G32

Suggested Citation

Wang, Qiuqi and Kwok, Yue Kuen, Real Option Signaling Games of Debt Financing Using Equity Guarantee Swaps (July 13, 2019). Wang, Q. and Kwok, Y. K. (2020). Real option signaling games of debt financing using equity guarantee swaps. International Journal of Theoretical and Applied Finance, 23(5), 2050036., Available at SSRN: https://ssrn.com/abstract=3442989 or http://dx.doi.org/10.2139/ssrn.3442989

Qiuqi Wang

University of Waterloo - Department of Statistics and Actuarial Science ( email )

Waterloo, Ontario N2L 3G1
Canada

Yue Kuen Kwok (Contact Author)

Hong Kong University of Science & Technology - Department of Mathematics ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

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