Financing with equity-for-guarantee swaps and dynamic investment under incomplete markets

Abstract

This paper develops a dynamic incomplete-markets model to analyse the impact of equity-for-guarantee swaps (EGSs), a financial innovation in China, on the interaction between an entrepreneur's initial financing and future dynamic investment policies. We compare the main implications generated by EGSs and traditional fee-for-guarantee swaps (FGSs). We demonstrate a twofold effect of EGSs on the firm: EGSs increase the firm's borrowing ability ex ante and thus allow the entrepreneur to enjoy a greater reduction in exposure to idiosyncratic business risk and undertake larger initial projects. However, EGSs aggravate the ex post underinvestment problem. Moreover, we argue that this additional underinvestment is more severe when entrepreneurs have higher risk aversion, the firm's capital is less liquid, the long- and short-term shocks to the firm's cash flow are larger, the corporate tax rate is higher, and the government provides higher subsidies to guarantors. Thus, our model yields a novel practical implication whereby EGSs' positive and negative real effects should be fully considered when decisions are made regarding their use.