Investment, consumption smoothing with credit guarantee and adverse selection

Abstract

This paper develops a single-period model of investments with credit guarantee swaps including Fee-for-Guarantee Swaps (FGSs), Equity-for-Guarantee Swaps (EGSs) and Option-for-Guarantee Swaps (OGSs). Enterprises have two types and high-quality enterprises suffer from adverse selection. The entrepreneurs are risk-averse while insurers are risk-neutral, taking on all default losses. We show that in pooling equilibria, high-quality enterprises are forced to transfer partial profits to low-quality ones. Even in separating equilibria, it is possible that high-quality enterprises suffer losses from adverse selection. As far as high-quality enterprises are concerned, OGS financing modes are the best, and they are more likely to reach separating equilibria than others. Only if the guarantee cost is feasible, the higher the strike price of the option, the higher the project value, and the optimal strike price makes guarantee cost arrive at its maximum feasible value.