An Algorithm for the Pricing and Timing of the Option to make a Two-Stage Investment with Credit Guarantees

Linjia Dong () and Zhaojun Yang
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Linjia Dong: Harbin Institute of Technology

Computational Economics, 2022, vol. 60, issue 3, No 15, 1175-1196

Abstract: Abstract We develop a jump-diffusion model for a guarantee-investment combination financing mode (G-I mode) that is recently popular in financial practice. We assume that a borrower has exclusively an option to invest in a project in two stages. The project’s cash flow follows a double exponential jump-diffusion process and it is increased by a growth factor once the second-stage investment is exercised. The first-stage investment cost is financed by a bank loan with the guarantee provided by an insurer, who promises to provide the second-stage investment cost as well as take the lender’s all default losses. In return for the guarantee and investment, the borrower pays a guarantee fee upon first investment and grants a fraction of equity upon second investment to the insurer. In sharp contrast to prior papers on guarantee, the guarantee costs are contracted prior to investment. We provide closed-form solutions and produce a numerical algorithm for the timing and pricing of the two investment options.

Keywords: Entrepreneurship; Guarantee-investment mode; Growth options; Jump-diffusion; Algorithms; G12; H81; G31 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (2)

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DOI: 10.1007/s10614-021-10220-8

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