Investment and asset securitization with an option‐for‐guarantee swap

• DOI: http://doi.org/10.1111/eufm.12250
• Author: Zhaojun Yang
• Published date: 01 September 2020
• Date: 01 September 2020

Eur Financ Manag. 2020;26:1006–1030.wileyonlinelibrary.com/journal/eufm1006

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© 2019 John Wiley & Sons Ltd.

DOI: 10.1111/eufm.12250

ORIGINAL ARTICLE

Investment and asset securitization with an

option‐for‐guarantee swap

Zhaojun Yang

Department of Finance, Southern

University of Science and Technology,

Shenzhen, China

Correspondence

Zhaojun Yang, Department of Finance,

Southern University of Science and

Technology, 518055 Shenzhen, China.

Email: yangzj@sustech.edu.cn

Abstract

This article addresses the investment and financing

decisions of entrepreneurs entering into option‐for‐

guarantee swaps (OGSs). OGSs increase investment option

value significantly. Entrepreneurs initially accelerate their

investments and then postpone them as funding gaps grow.

Guarantee costs increase with project risks when the

funding gap is sufficiently small or large, but the opposite

holds true otherwise. Investments are postponed when

project risks, effective tax rates, or bankruptcy costs

increase. Surprisingly, the higher the project risk, the more

the entrepreneur will borrow, with a much higher leverage

than predicted by classic models. Entrepreneurs can use

OGSs to securitize their assets.

KEYWORDS

asset securitization, capital structure, credit default swap, real options

JEL CLASSIFICATION

G12; G23

EUROPEAN

FINANCIAL MANAGEMENT

I thank the editor, John Doukas, and an anonymous referee for their constructive comments, which have been very

helpful in improving the article. I am grateful for the helpful comments of Xuedong He and other participants at the

Twelfth Annual Risk Management Conference, organized by the Risk Management Institute (RMI) of the National

University of Singapore, Singapore. RMI's financial support is greatly appreciated. I also thank Izidin El Kalak and other

participants, including Hai Zhang, at the European Financial Management Association 2019 Conference. I am very

grateful to Xiaolin Tang and Xiang Liu for their great help. The data provided by Suhua Liu, the chair of Shenzhen

High‐Tech Investment Group Co., Ltd., are highly appreciated. The research reported in this article was supported by

the National Natural Science Foundation of China (Project No. 71371068) and the Special Innovation Projects of

Universities in Guangdong (Project No. 2018WTSCX131).

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INTRODUCTION

Many countries have experienced rapid economic growth since the 1980s. Due to the very strict

requirements for initial public offerings of equity, many companies have been unable to access equity

financing, and a trip to the debt market is the last resort. In 2013, bank loans represented 84.5% and

bond issuances represented 10.5% of the total capital raised through formal channels in China, with

equity offerings representing only 1.3% (Liu, Cullinan, Zhang, & Wang, 2016). Debt financing is

therefore a major source of capital for Chinese companies, especially small‐and medium‐sized

enterprises (SMEs). Although SMEs represent 99% ofallcompaniesandplayavitalroleinpromoting

economic growth throughout the world, it is difficult for them to obtain bank loans. Therefore, a large

number of SMEs have had to forgo investments in projects, even if they are very profitable. This

situation has become even more serious due to the recent global financial crisis.

To overcome financing constraints, some SMEs have turned to insurers, entering into equity

default swap (EDS) agreements with an insurer and a lender (bank). The amount of guaranteed loans

was more than twice the amount of equity financing during the first half of 2013 (Shan & Tang, 2019),

while more than 79% of bank loans were insured (World Bank Enterprise Surveys). In addition, peer‐

to‐peer lending has been gaining in popularity, playing a positive role in inclusive finance. Since

mandatory payment arrangements are forbidden in China, to protect inexperienced investors, many

peer‐to‐peer lending platforms require a third party to guarantee loans, such that guarantee services

have become increasingly popular. According to a report from the Forward‐Looking Industrial

Institution,

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there are as many as 8,025 guarantee institutions in China, and the amount of

outstanding guaranteed debt reached RMB 3.37 trillion in 2017.

Many SMEs throughout the world, especially high‐tech enterprises in the start‐up stage, are

characterized by high risks and high returns. In the meanwhile, they often fail to provide effective

mortgages or counter‐guarantee measures. To support such SMEs, some insurers, supported by their

local governments, charge them a guarantee fee (0.5–2%) under the fee‐for‐guarantee swap (FGS).

However, the low premium income cannot cover default risk adequately, leading to a mismatch

between risk and return faced by insurers with limited government subsidies. This is also a common

problem worldwide (Calice, 2016; Honohan, 2010).

Shenzhen High‐tech Investment Group Co., Ltd. (HTI) therefore combined a credit guarantee

with venture capital to keep itself financially sustainable and made explorations into the venture

capital business. From 1999–2000, as a supplement to FGSs, new agreements of guarantee with

investments were initiated, such as option‐for‐guarantee swaps (OGSs), equity‐for‐guarantee swaps

(EGSs), and direct investments. This article focuses mainly on analyzing OGSs.

An OGS is a three‐party agreement between a bank/lender, an insurer, and an SME/borrower,

where the borrower obtains a loan from the lender at a given interest rate and, if the borrower

defaults on the loan, the insurer must pay all the outstanding interest and principal to the lender. In

return, the borrower must provide the insurer with a call option to buy a given fraction of equity at a

given exercise price per share. OGSs are similar to credit default swaps (CDSs), which are designed to

transfer the credit exposure of fixed‐income products between parties. In a CDS, the purchaser of the

swap makes payments (the CDS fee or spread) up until the maturity date of the contract to the seller

of the swap. In return, the seller agrees to pay off a third‐party debt if this party defaults on the loan

(e.g.,Longstaff,Mithal,&Neis,2005).Furthermore,OGSsaremoresimilartoEDSs

(Mendoza‐Arriaga & Linetsky, 2011), which are designed to deliver a protection payment to the

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See https://www.qianzhan.com/analyst/detail/220/190218‐ee9f6fe6.html.

YANG EUROPEAN

FINANCIAL MANAGEMENT

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