Option‐for‐guarantee swaps and flexible investment opportunities

Liu Gan and Chong Wang

International Review of Finance, 2021, vol. 21, issue 4, 1286-1301

Abstract: This paper develops a dynamic structural model to study the interaction between an entrepreneur's initial financing choice and future investment decisions when the firm is financed by an option‐for‐guarantee swap (OGS) contract. We begin under the assumption that the guarantee cost is determined by the bargaining between the entrepreneur and the guarantor at the initial time, and the entrepreneur can exercise investment at each time to adjust the firm's size. We show that both the market leverage ratio and agency cost of debt overhang exhibit a U‐shaped relation with the entrepreneur's bargaining power. Moreover, our model predicts an inverted U‐shaped relationship between the agency cost of debt overhang and the profitability of investment opportunities. In particular, compared to the traditional fee‐for‐guarantee swaps (FGSs), we also demonstrate that firms with OGS financing have a larger bargaining region between the entrepreneur and the guarantor. This means that OGSs can make it easier for the entrepreneur escape initial financial constraints and thus can provide a novel investment‐based explanation for the use of OGSs.

Date: 2021
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