The Learning, Timing, and Pricing of the Option to Invest With Guaranteed Debt and Asymmetric Information

42 Pages Posted: 7 Sep 2019 Last revised: 29 Sep 2019

See all articles by Pengfei Luo

Pengfei Luo

Hunan University - School of Finance and Statistics

Huamao Wang

University of Kent - Kent Business School

Zhaojun Yang

Southern University of Science and Technology - Department of Finance

Date Written: September 1, 2019

Abstract

We assume a borrower must borrow from a lender to start a project. The debt is secured by an insurer taking the project and the lender's loss at default. The borrower grants the insurer a fraction of the money borrowed (fee-for-guarantee swap, FGS) or of the project's equity (equity-for-guarantee swap, EGS) as guarantee cost. The borrower knows the project's expected growth rate, but the insurer merely knows it to take a high or low value. Insurers learn about the growth rate and dynamically update their beliefs. We show that asymmetric information makes a high-type borrower pay a higher guarantee cost than usual. The learning accelerates the high-type borrower's investment and reduces the guarantee cost and adverse selection cost. A sufficiently high initial belief on the high-type borrower or a sufficiently large funding gap makes pooling equilibrium Pareto dominate separating equilibrium. FGSs are superior to EGSs.

Keywords: Real options, Secured debt, Asymmetric information, Bayesian learning, Signaling game

JEL Classification: G13, G31, D82, C73

Suggested Citation

Luo, Pengfei and Wang, Huamao and Yang, Zhaojun, The Learning, Timing, and Pricing of the Option to Invest With Guaranteed Debt and Asymmetric Information (September 1, 2019). Available at SSRN: https://ssrn.com/abstract=3445784 or http://dx.doi.org/10.2139/ssrn.3445784

Pengfei Luo

Hunan University - School of Finance and Statistics ( email )

Shijiachong Road 109#
Changsha, Hunan 410079
China

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

Register to save articles to
your library

Register

Paper statistics

Downloads
29
Abstract Views
197
PlumX Metrics