Investment Analysis under Equity Default Swaps with Asymmetric Information

Abstract

We assume an entrepreneur (borrower) must borrow money from a lender (bank) to start a project in a single-period model. The debt is secured by an insurer who takes the project and pays the lender all the outstanding principal and interest in case of default. The borrower grants the insurer a fraction of the money borrowed, or of the project's payoff, or of a call option underlying on the project payoff. The corresponding three parties' agreement is called the fee-for-guarantee swap (FGS), equity-for-guarantee swap (EGS), and option-for-guarantee swap (OGS) respectively. We assume the project payoff follows a lognormal distribution. The variance of its logarithm is common knowledge but the mean is only known to the borrower and follows a two-point distribution to the insurer, i.e. there exists asymmetric information. We show that asymmetric information benefits low-profitability borrowers or insurers at the expense of high-profitability ones. The benefit and expense under OGS are the most while those under FGS are the least. In a pooling equilibrium, a high-profitability borrower must transfer a fraction of its profit to the low-profitability one. There is no social welfare loss only if the net investment value of the low-profitability project is positive. In a separating equilibrium, the high-profitability borrower might transfer a fraction of its profit to the insurer and surprisingly, the net investment value of a high-profitability borrower increases with investment cost.