Learning, timing and pricing of the option to invest with loan guarantees

Abstract

This paper develops a dynamic model to examine the pricing and timing of borrowers' options to invest in a project by issuing guaranteed debt. Insurers face adverse selection and learn project quality from public information. Our model provides empirical predictions for high-quality borrowers: Learning alleviates adverse selection, reduces guarantee costs, and increases investment option values. These effects are more pronounced if uncertainty is higher. A separating or pooling equilibrium is reached, depending on the economic environment. Learning makes high-quality borrowers postpone investment but makes them accelerate investment if a pooling equilibrium is reached. Two guarantee mechanisms are compared.

Keywords: Real options, Alternative CDS, Asymmetric information, Bayesian learning, Signaling game.

JEL Classification: H81, D82, D83