Option-for-Guarantee Swap and Equity-for-Guarantee Swap with Idiosyncratic Risk

Abstract

We investigate two new types of equity default swaps: an equity-for-guarantee swap (EGS) and an option-for-guarantee swap (OGS). We calculate equilibrium prices for all components of the two swaps. Then we switch to utility-based prices of the entrepreneur's claims. Our analysis shows that under the equilibrium pricing, EGS is better than OGS but under the utility-based pricing, OGS is generally better than EGS. The OGS advantage over EGS increases quickly with the firm's cash flow level and is generally more pronounced when either the risk aversion, cash flow risk or the correlation between the cash flow and the market increases.