Investment and Financing for SMEs with a Partial Guarantee and Jump Risk

24 Pages Posted: 8 Feb 2015

See all articles by Pengfei Luo

Pengfei Luo

Hunan University - School of Finance and Statistics

Huamao Wang

University of Kent - Kent Business School

Zhaojun Yang

Southern University of Science and Technology - Department of Finance

Date Written: February 7, 2015

Abstract

Many SMEs and young entrepreneurs experience financing constraints due to their low credibility and information asymmetry. To this end, a partial guarantee agreement is popular with Chinese entrepreneurs. In this paper, we consider an SME with a funding gap, who wants to invest in a project, of which the cash flow follows a double exponential jump-diffusion process. In contrast to traditional corporate finance theory, we assume the SME is unable to get loan directly from banks because of its high project risk, strong information asymmetry and low credibility of SMEs. To overcome such financing constraints, the SME turns to an insurer and enters into a partial guarantee agreement, where a bank lends cash to the SME with the insurer promising to undertake a fraction (guarantee level) of debt once the SME defaults. In return, the SME (borrower) allocates a fraction of equity and a fixed guarantee fee rate per unit time to the insurer. We assume the investment is irreversible and can be postponed. Utilizing a real options approach, we develop an investment and financing model with the partial guarantee. We explicitly derive the pricing and timing of the option to invest for the cash flow with both diffusion and jump risk. The two sources of project risk increase the value of the option and postpone investment. More importantly, we reveal that larger funding gaps or higher guarantee levels lead to a later investment and generally a slightly less value of the option to invest. Interestingly, raising the guarantee level can effectively reduce the borrower's moral hazard to increase equity values at the expense of the lender. Meanwhile, an increase in the guarantee level does not add disincentive for the SME to replenish its equity.

Keywords: Guarantee level, Investment and financing, Real options, Double exponential jump-diffusion process

JEL Classification: G11, G32

Suggested Citation

Luo, Pengfei and Wang, Huamao and Yang, Zhaojun, Investment and Financing for SMEs with a Partial Guarantee and Jump Risk (February 7, 2015). Asian Finance Association (AsianFA) 2015 Conference Paper, Available at SSRN: https://ssrn.com/abstract=2561731 or http://dx.doi.org/10.2139/ssrn.2561731

Pengfei Luo

Hunan University - School of Finance and Statistics ( email )

Shijiachong Road 109#
Changsha, Hunan 410079
China

Huamao Wang

University of Kent - Kent Business School ( email )

Sibson Building
Canterbury, Kent CT2 7FS
United Kingdom

Zhaojun Yang (Contact Author)

Southern University of Science and Technology - Department of Finance ( email )

No 1088, Xueyuan Rd.
District of Nanshan
Shenzhen, Guangdong 518055
China

HOME PAGE: http://faculty.sustc.edu.cn/profiles/yangzj

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
122
Abstract Views
1,227
rank
309,209
PlumX Metrics