The pricing of conditional performance guarantees with risky collateral

Abstract

Conditional performance guarantees with risky collaterals are specific bonding instruments that are not credit extensions or require only a service fee. Instead, they resemble a credit default swap (CDS) that is essentially an insurance contract and can thus be priced accordingly. A CDS‐based model is proposed here for pricing these instruments. The model incorporates both contractor default probability and the recovery risk of collateral. It also allows for explicit specification of bonding parameters such as the promised amount of payment in the event of default. For model implementation, a quasi‐KMV–Merton approach is proposed for the estimation of contractor default probability. The historical market prices and basic accounting data of publicly traded construction firms in the Taiwan Economic Journal Database (TEJD) are used to test the model. The model demonstrates effective statistical power to distinguish categorized samples of the firms. It shows that the current industrial practice of asking a standard service rate of 1% tends to charge too little for financially distressed firms and too much for normal ones.

Keywords:

• Guarantees
• contractor default probability
• collateral
• credit default swap
• pricing
• models