Consumption And Financing Choice Of SME Entrepreneurs With An Equity-for-guarantee Swap

In order to solve the financing difficulties of Small and Medium SizedEnterprises (SMEs) in China, this paper demonstrates the necessity and feasibility ofestablishing an innovative Credit Guarantee Scheme based on equity-for-guaranteeswap and Contingent Convertible Bonds. These innovative financial products are vitalfor guarantee companies to make profits and raise capitals, whose design is theprerequisite and foundation of the stability and efficiency of the innovative CreditGuarantee Scheme.We have developed closed-form price of the guarantee cost (i.e. part of SME’sequity) and a framework that SMEs capital structure and Pareto improvement can beeasily analyzed through numerical solutions. Through the numerical solutions, weconclude that equity-for-guarantee reduces the extent of the information asymmetrysignificantly. Thus welfare loss is circumvented and implementation Pareto isimproved remarkably. We also numerically show that the innovative contractcontributes to a higher value of the SME than issui ng fully protected debt, whichleads to lower SME’s welfare improvement. Above all, we c onclude that theinnovative contract is efficient in rendering safer SMEs, thus alleviating SMEsserious financing constraints and leading to Pareto improvement. Interestingly,negative correlation coefficient leads to lower guarantee costs and higher leverage.Moreover, Pareto improvement value is an increase function of volatility whencorrelation coefficient is negative, which is quite different from the basic case.Under the assumption that SME entrepreneurs are risk-averse, we develop aconsumption utility-based pricing model for corporate securities’ subject values, riskpremiums and SMEs’ capital structure incorporating endogenous borrowingconstraints with an equity-for-guarantee swap. The model is solved by dynamicprogramming and the risk premiums are presented analytically. We find thatidiosyncratic business risk for a risk-averse entrepreneur has impact on consumption,portfolio allocation and financing choice of the entrepreneur. The more theentrepreneur is risk-averse, the higher the leverage is and the less the presententrepreneur consumes. A risk-averse entrepreneur will lower market portfolioholdings, default earlier to hedge downside risk and demand a higher idiosyncraticrisk premium to mitigate the shock of idiosyncratic business risk on investment andconsumption.