Essays in financial guarantees and risky debt

Abstract: This dissertation consists of six separate papers dealing with the valuation of financial guarantees and risky debt contract. Each of these papers is independent and distinct. The main theme is the valuation of securities by contingent claims analysis (CCA).Paper 1: Valuation of Financial Guarantees – A Presentation and a Critique.One purpose of this paper is to derive a pricing formula for a deposit guarantee, when the assets of the bank exhibit downward jumps due to extraordinary loan defaults. In this respect, we use the framework of Merton (1976), where a stock option is priced under the assumption of a jump-diffusion process for the underlying stock.Paper 2: Valuation of Deposit Insurance – An Alternative Approach.This paper extends paper 1 in the respect that the guarantor, in this case a deposit insurance agency, will nullify the guarantee contract and liquidate the bank when it gets insolvent. The liquidation is assumed to involve some costs like legal and realization costs. In fact, since the guarantee contract will never get in-the-money, the guarantee will receive value only from these liquidation costs.Paper 3: Financial Guarantees and Asymmetric Information.In this paper, we make the assumption that the guarantor cannot observe the solvency process, unless it carries out audits. This is different from the normal perfect information assumption for this kind of analysis. Since audits are often costly, and this burdens the guarantee value, the guarantor will search for an audit strategy, which minimizes the guarantee value.Paper 4: Valuation of Barrier Contracts – A Simplified Approach.Many types of financial contracts can be classified as "barrier contracts". This description comes from their feature of allowing either contractual part to take some kind of action during the lifetime of the contract contingent on some pre-specified event. In this sense, the deposit insurance contract in analysed in paper 2 can be regarded as a barrier contract.The previous valuation models of barrier contracts are often considerably advanced and have tended to obscure the underlying economics. It is the path-dependence and stopping-time features that primarily make the derivation of these pricing formulas complicated. Our model simplifies this procedure by deriving the important "first passage time" distribution from a binomial model instead of using the reflection principle.Paper 5: Valuation of Risky Debt in the Presence of Jumps, Safety Barriers and Collaterals.This paper deals with different aspects of risky debt valuation with the CCA approach. The term. "risky", refers to the probability of default on the promised payment by the borrower.Paper 6: Portfolio Selection and the Pricing of Personal Loan Contracts.The CCA literature that follows Black and Scholes (1973), has mainly taken the underlying asset dynamics for given. Although it may be appropriate for stock options, we consider this assumption too simplifying with regards to personal loan contracts. It is obvious that the borrower’s consumption-investment decision affects his wealth process, on which the loan contract is contingent. Moreover, we believe that individuals actually have preferences to repay loans for different reasons such as the existence of reputational costs or legal penalties that affect the borrower in case of loan default.