Credit risk in infrastructure PPP projects under the real options approach

Abstract

The purpose of the paper is to provide a method to estimate the credit risk in infrastructure public–private partnership (PPP) projects by using a structural model, the Real Options approach, and the Monte Carlo simulation technique. To do that, previous models are extended under a structural framework for credit risk where the embedded options in the credit agreement such as the option to renegotiate and the option to exit are introduced as well as the uncertainty of the cash flows. In that sense, all the components of expected loss (EL) such as the probability of default, the exposure, and the recovery rate for lenders are modelled and estimated in a PPP toll road project by considering the embedded options as well as the default events. Consequently, it is found that the embedded options improve the recovery rate for lenders and their EL. Additionally, practical insights about the effects of the embedded options in the credit agreement and the probability of default are provided.

Keywords:

• Infrastructure projects
• real options
• credit risk
• control rights

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Furthermore, flexibility is the condition that determines the existence of real options to make optimal investment decisions and, hence, the possibility of taking optimal alternative courses.

2 Starting from the seminal works of Black and Scholes (1973) and Merton (1973), the contingent claims analyses (CCA) have been adapted for the treatment of corporate problems; one of them is the measure of credit risk. This field includes the structural models for credit risk assessment initiated by Merton (1974).

3 Moreover, according to Gatti (2008), from the decision-making viewpoint, a minimum DSCR is usually used by lenders in the loan negotiation phase and their conditions to help them decide the optimal debt-to-equity ratio of the deal.

5 For simplicity, we assume that renegotiation takes place at the same time when technical default occurs.

6 Although the proposed model is like the one of Hasan and Blanc-Brude (2017), $V_{WK}$ incorporates the changes about the newly scheduled debt service repayment flow (${DS}_t^{\prime }$) when the restructuring scenario takes place.

7 The BOMT is one of the significant nonrecourse project financing schemes in practice.

8 See Brandão et al. (2012) for more details.

10 Since it is assumed that the project value follows a GBM, the volatility is constant over the project life.

11 Unlike the BBH-I model we did not implement the Black and Cox (1976) model.

12 The results are in line with Pawlina (2010) who argued that the option to renegotiate debt generally has a higher value than an analogous option to go bankrupt, which is in our case represents the option to exit.

13 According to Gatti (2008), VaR is a measure of the risk of loss and it can be defined as the maximum possible loss during the time given normal market conditions.